Is Shandong Hualu-Hengsheng Chemical (SHSE:600426) 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.' 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. As with many other companies Shandong Hualu-Hengsheng Chemical Co., Ltd. (SHSE:600426) makes use of debt. But is this debt a concern to shareholders?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

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 September 2024, Shandong Hualu-Hengsheng Chemical had CN¥8.96b of debt, up from CN¥7.51b a year ago. Click the image for more detail. However, it does have CN¥1.86b in cash offsetting this, leading to net debt of about CN¥7.11b.

A Look At Shandong Hualu-Hengsheng Chemical's Liabilities

According to the last reported balance sheet, Shandong Hualu-Hengsheng Chemical had liabilities of CN¥5.75b due within 12 months, and liabilities of CN¥8.44b due beyond 12 months. Offsetting this, it had CN¥1.86b in cash and CN¥2.52b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥9.81b.

Shandong Hualu-Hengsheng Chemical has a market capitalization of CN¥44.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shandong Hualu-Hengsheng Chemical's net debt is only 0.98 times its EBITDA. And its EBIT easily covers its interest expense, being 24.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Shandong Hualu-Hengsheng Chemical grew its EBIT by 16% last year, making its debt load easier to handle. 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'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 it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Shandong Hualu-Hengsheng Chemical actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

When it comes to the balance sheet, the standout positive for Shandong Hualu-Hengsheng Chemical was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. In particular, conversion of EBIT to free cash flow gives us cold feet. Looking at all this data makes us feel a little cautious about Shandong Hualu-Hengsheng Chemical's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 1 warning sign we think you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.