Is Hubei Zhenhua ChemicalLtd (SHSE:603067) A Risky Investment?

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.' 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. Importantly, Hubei Zhenhua Chemical Co.,Ltd. (SHSE:603067) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hubei Zhenhua ChemicalLtd

What Is Hubei Zhenhua ChemicalLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Hubei Zhenhua ChemicalLtd had CN¥988.7m of debt, an increase on CN¥851.7m, over one year. However, because it has a cash reserve of CN¥186.0m, its net debt is less, at about CN¥802.8m.

How Healthy Is Hubei Zhenhua ChemicalLtd's Balance Sheet?

The latest balance sheet data shows that Hubei Zhenhua ChemicalLtd had liabilities of CN¥705.1m due within a year, and liabilities of CN¥748.0m falling due after that. On the other hand, it had cash of CN¥186.0m and CN¥913.6m worth of receivables due within a year. So its liabilities total CN¥353.5m more than the combination of its cash and short-term receivables.

Given Hubei Zhenhua ChemicalLtd has a market capitalization of CN¥5.90b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Hubei Zhenhua ChemicalLtd has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 14.4 times the size. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Hubei Zhenhua ChemicalLtd has seen its EBIT plunge 16% 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 ultimately the future profitability of the business will decide if Hubei Zhenhua ChemicalLtd can strengthen its balance sheet over time. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Hubei Zhenhua ChemicalLtd's free cash flow amounted to 25% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Hubei Zhenhua ChemicalLtd's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at (not) growing its EBIT as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we do feel a bit cautious about Hubei Zhenhua ChemicalLtd's use of debt. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Hubei Zhenhua ChemicalLtd you should know about.

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.