Here's Why Shandong Hualu-Hengsheng Chemical (SHSE:600426) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, Shandong Hualu-Hengsheng Chemical Co., Ltd. (SHSE:600426) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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 Shandong Hualu-Hengsheng Chemical

What Is Shandong Hualu-Hengsheng Chemical's Debt?

As you can see below, at the end of June 2024, Shandong Hualu-Hengsheng Chemical had CN¥8.57b of debt, up from CN¥6.57b a year ago. Click the image for more detail. However, it does have CN¥1.70b in cash offsetting this, leading to net debt of about CN¥6.88b.

How Strong Is Shandong Hualu-Hengsheng Chemical's Balance Sheet?

We can see from the most recent balance sheet that Shandong Hualu-Hengsheng Chemical had liabilities of CN¥4.99b falling due within a year, and liabilities of CN¥8.25b due beyond that. Offsetting these obligations, it had cash of CN¥1.70b as well as receivables valued at CN¥2.26b due within 12 months. So it has liabilities totalling CN¥9.28b more than its cash and near-term receivables, combined.

Of course, Shandong Hualu-Hengsheng Chemical has a market capitalization of CN¥51.1b, so these liabilities are probably manageable. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shandong Hualu-Hengsheng Chemical has a low net debt to EBITDA ratio of only 0.87. And its EBIT easily covers its interest expense, being 31.0 times the size. So we're pretty relaxed about its super-conservative use of debt. Also positive, Shandong Hualu-Hengsheng Chemical grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. 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 Shandong Hualu-Hengsheng 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shandong Hualu-Hengsheng Chemical recorded negative free cash flow, in total. 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

The good news is that Shandong Hualu-Hengsheng Chemical's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Shandong Hualu-Hengsheng Chemical can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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 - Shandong Hualu-Hengsheng Chemical has 1 warning sign we think you should be aware of.

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.