We Think Gansu Energy Chemical (SZSE:000552) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Gansu Energy Chemical

How Much Debt Does Gansu Energy Chemical Carry?

As you can see below, at the end of September 2024, Gansu Energy Chemical had CN¥6.56b of debt, up from CN¥5.57b a year ago. Click the image for more detail. But it also has CN¥6.61b in cash to offset that, meaning it has CN¥54.3m net cash.

How Strong Is Gansu Energy Chemical's Balance Sheet?

The latest balance sheet data shows that Gansu Energy Chemical had liabilities of CN¥5.74b due within a year, and liabilities of CN¥8.80b falling due after that. Offsetting this, it had CN¥6.61b in cash and CN¥1.20b in receivables that were due within 12 months. So it has liabilities totalling CN¥6.74b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Gansu Energy Chemical is worth CN¥14.7b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. 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.

In fact Gansu Energy Chemical's saving grace is its low debt levels, because its EBIT has tanked 46% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Gansu Energy Chemical can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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. Over the last three years, Gansu Energy Chemical reported free cash flow worth 2.9% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

Although Gansu Energy Chemical's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥54.3m. 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. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Gansu Energy Chemical (at least 1 which is significant) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.