Here's Why Hubei Xingfa Chemicals Group (SHSE:600141) Has A Meaningful Debt Burden

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Hubei Xingfa Chemicals Group Co., Ltd. (SHSE:600141) does carry debt. But should shareholders be worried about its use of debt?

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Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Hubei Xingfa Chemicals Group Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Hubei Xingfa Chemicals Group had debt of CN¥13.7b, up from CN¥12.5b in one year. On the flip side, it has CN¥1.87b in cash leading to net debt of about CN¥11.8b.

How Strong Is Hubei Xingfa Chemicals Group's Balance Sheet?

The latest balance sheet data shows that Hubei Xingfa Chemicals Group had liabilities of CN¥13.8b due within a year, and liabilities of CN¥10.7b falling due after that. Offsetting this, it had CN¥1.87b in cash and CN¥2.93b in receivables that were due within 12 months. So its liabilities total CN¥19.7b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥24.8b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

View our latest analysis for Hubei Xingfa Chemicals Group

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Hubei Xingfa Chemicals Group's net debt of 2.3 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.9 times interest expense) certainly does not do anything to dispel this impression. One way Hubei Xingfa Chemicals Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Hubei Xingfa Chemicals Group'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Hubei Xingfa Chemicals Group's free cash flow amounted to 38% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Hubei Xingfa Chemicals Group's level of total liabilities does give us pause, its EBIT growth rate and interest cover suggest it can stay on top of its debt load. Looking at all the angles mentioned above, it does seem to us that Hubei Xingfa Chemicals Group is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Hubei Xingfa Chemicals Group (of which 1 is potentially serious!) you should know about.

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.