These 4 Measures Indicate That Haohua Chemical Science & Technology (SHSE:600378) Is Using Debt Extensively

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. We note that Haohua Chemical Science & Technology Corp., Ltd. (SHSE:600378) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Haohua Chemical Science & Technology

How Much Debt Does Haohua Chemical Science & Technology Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Haohua Chemical Science & Technology had CN¥4.34b of debt, an increase on CN¥2.41b, over one year. However, it does have CN¥1.96b in cash offsetting this, leading to net debt of about CN¥2.37b.

A Look At Haohua Chemical Science & Technology's Liabilities

According to the last reported balance sheet, Haohua Chemical Science & Technology had liabilities of CN¥9.51b due within 12 months, and liabilities of CN¥3.68b due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.96b as well as receivables valued at CN¥4.98b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.25b.

Since publicly traded Haohua Chemical Science & Technology shares are worth a total of CN¥31.3b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Haohua Chemical Science & Technology's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. Shareholders should be aware that Haohua Chemical Science & Technology's EBIT was down 38% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Haohua Chemical Science & Technology can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the last three years, Haohua Chemical Science & Technology saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Haohua Chemical Science & Technology's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Haohua Chemical Science & Technology stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Haohua Chemical Science & Technology is showing 2 warning signs in our investment analysis , you should know about...

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.