We Think Shandong Hualu-Hengsheng Chemical (SHSE:600426) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 can see that Shandong Hualu-Hengsheng Chemical Co., Ltd. (SHSE:600426) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, 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 2023, Shandong Hualu-Hengsheng Chemical had CN¥7.51b of debt, up from CN¥3.72b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥2.24b, its net debt is less, at about CN¥5.27b.

A Look At Shandong Hualu-Hengsheng Chemical's Liabilities

The latest balance sheet data shows that Shandong Hualu-Hengsheng Chemical had liabilities of CN¥4.49b due within a year, and liabilities of CN¥7.17b falling due after that. On the other hand, it had cash of CN¥2.24b and CN¥2.24b worth of receivables due within a year. So its liabilities total CN¥7.18b more than the combination of its cash and short-term receivables.

Of course, Shandong Hualu-Hengsheng Chemical has a market capitalization of CN¥57.3b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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 0.80. And its EBIT easily covers its interest expense, being 205 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Shandong Hualu-Hengsheng Chemical's saving grace is its low debt levels, because its EBIT has tanked 46% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into 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

Neither Shandong Hualu-Hengsheng Chemical's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Shandong Hualu-Hengsheng Chemical's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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, we've discovered 3 warning signs for Shandong Hualu-Hengsheng Chemical (1 is a bit unpleasant!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.