Is Hengli PetrochemicalLtd (SHSE:600346) Using Too Much Debt?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Hengli Petrochemical Co.,Ltd. (SHSE:600346) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Hengli PetrochemicalLtd

How Much Debt Does Hengli PetrochemicalLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Hengli PetrochemicalLtd had CN¥158.4b of debt, an increase on CN¥132.5b, over one year. However, because it has a cash reserve of CN¥25.5b, its net debt is less, at about CN¥132.9b.

A Look At Hengli PetrochemicalLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Hengli PetrochemicalLtd had liabilities of CN¥130.3b due within 12 months and liabilities of CN¥80.1b due beyond that. Offsetting this, it had CN¥25.5b in cash and CN¥6.54b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥178.4b.

The deficiency here weighs heavily on the CN¥113.6b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Hengli PetrochemicalLtd would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Hengli PetrochemicalLtd has a rather high debt to EBITDA ratio of 5.5 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.6 times, suggesting it can responsibly service its obligations. The silver lining is that Hengli PetrochemicalLtd grew its EBIT by 3,703% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Hengli PetrochemicalLtd 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. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Hengli PetrochemicalLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Hengli PetrochemicalLtd's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Hengli PetrochemicalLtd's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Hengli PetrochemicalLtd is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.