Is Shandong Hualu-Hengsheng Chemical (SHSE:600426) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Shandong Hualu-Hengsheng Chemical Co., Ltd. (SHSE:600426) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider 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 March 2024, Shandong Hualu-Hengsheng Chemical had CN¥8.29b of debt, up from CN¥4.68b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥2.20b, its net debt is less, at about CN¥6.09b.

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

Zooming in on the latest balance sheet data, we can see that Shandong Hualu-Hengsheng Chemical had liabilities of CN¥5.34b due within 12 months and liabilities of CN¥8.01b due beyond that. Offsetting these obligations, it had cash of CN¥2.20b as well as receivables valued at CN¥2.86b due within 12 months. So it has liabilities totalling CN¥8.29b more than its cash and near-term receivables, combined.

Given Shandong Hualu-Hengsheng Chemical has a market capitalization of CN¥55.7b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

Shandong Hualu-Hengsheng Chemical has a low net debt to EBITDA ratio of only 0.88. And its EBIT covers its interest expense a whopping 41.6 times over. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Shandong Hualu-Hengsheng Chemical has seen its EBIT plunge 11% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Shandong Hualu-Hengsheng Chemical's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding 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

Shandong Hualu-Hengsheng Chemical's conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Shandong Hualu-Hengsheng Chemical 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. However, not all investment risk resides within the balance sheet - far from it. For example Shandong Hualu-Hengsheng Chemical has 2 warning signs (and 1 which is a bit concerning) we think you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com