Does Wanhua Chemical Group (SHSE:600309) Have A Healthy Balance Sheet?

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.' 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, Wanhua Chemical Group Co., Ltd. (SHSE:600309) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Wanhua Chemical Group

What Is Wanhua Chemical Group's Debt?

As you can see below, at the end of September 2023, Wanhua Chemical Group had CN¥128.1b of debt, up from CN¥75.4b a year ago. Click the image for more detail. On the flip side, it has CN¥40.1b in cash leading to net debt of about CN¥88.0b.

How Healthy Is Wanhua Chemical Group's Balance Sheet?

According to the last reported balance sheet, Wanhua Chemical Group had liabilities of CN¥120.8b due within 12 months, and liabilities of CN¥45.6b due beyond 12 months. On the other hand, it had cash of CN¥40.1b and CN¥13.1b worth of receivables due within a year. So its liabilities total CN¥113.1b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Wanhua Chemical Group has a huge market capitalization of CN¥244.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Wanhua Chemical Group has a debt to EBITDA ratio of 3.1, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 18.9 is very high, suggesting that the interest expense on the debt is currently quite low. Importantly Wanhua Chemical Group's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Wanhua Chemical 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Wanhua Chemical Group actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Neither Wanhua Chemical Group's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Wanhua Chemical Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Wanhua Chemical Group that you should be aware of before investing here.

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.

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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.