Here's Why Shan Dong Lu Bei ChemicalLtd (SHSE:600727) Has A Meaningful Debt Burden

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Shan Dong Lu Bei Chemical Co.,Ltd (SHSE:600727) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. 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.

Check out our latest analysis for Shan Dong Lu Bei ChemicalLtd

How Much Debt Does Shan Dong Lu Bei ChemicalLtd Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Shan Dong Lu Bei ChemicalLtd had debt of CN¥2.60b, up from CN¥661.3m in one year. However, because it has a cash reserve of CN¥2.36b, its net debt is less, at about CN¥245.7m.

A Look At Shan Dong Lu Bei ChemicalLtd's Liabilities

According to the last reported balance sheet, Shan Dong Lu Bei ChemicalLtd had liabilities of CN¥5.12b due within 12 months, and liabilities of CN¥167.3m due beyond 12 months. Offsetting this, it had CN¥2.36b in cash and CN¥1.15b in receivables that were due within 12 months. So its liabilities total CN¥1.78b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Shan Dong Lu Bei ChemicalLtd is worth CN¥3.95b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Shan Dong Lu Bei ChemicalLtd has a low debt to EBITDA ratio of only 0.48. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. It was also good to see that despite losing money on the EBIT line last year, Shan Dong Lu Bei ChemicalLtd turned things around in the last 12 months, delivering and EBIT of CN¥245m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shan Dong Lu Bei ChemicalLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Shan Dong Lu Bei ChemicalLtd 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

We feel some trepidation about Shan Dong Lu Bei ChemicalLtd's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Shan Dong Lu Bei ChemicalLtd is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Shan Dong Lu Bei ChemicalLtd (1 is concerning) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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.