Here's Why Gansu Energy Chemical (SZSE:000552) Has A Meaningful Debt Burden

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Gansu Energy Chemical Co., Ltd. (SZSE:000552) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Gansu Energy Chemical

What Is Gansu Energy Chemical's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Gansu Energy Chemical had debt of CN¥6.15b, up from CN¥5.33b in one year. However, its balance sheet shows it holds CN¥8.14b in cash, so it actually has CN¥1.99b net cash.

How Strong Is Gansu Energy Chemical's Balance Sheet?

According to the last reported balance sheet, Gansu Energy Chemical had liabilities of CN¥6.00b due within 12 months, and liabilities of CN¥8.14b due beyond 12 months. On the other hand, it had cash of CN¥8.14b and CN¥1.68b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥4.32b.

While this might seem like a lot, it is not so bad since Gansu Energy Chemical has a market capitalization of CN¥14.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Gansu Energy Chemical also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Gansu Energy Chemical if management cannot prevent a repeat of the 54% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Gansu Energy Chemical's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Gansu Energy Chemical may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Gansu Energy Chemical recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While Gansu Energy Chemical does have more liabilities than liquid assets, it also has net cash of CN¥1.99b. So although we see some areas for improvement, we're not too worried about Gansu Energy Chemical's balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Gansu Energy Chemical is showing 4 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.