These 4 Measures Indicate That Hubei Zhenhua ChemicalLtd (SHSE:603067) Is Using Debt Reasonably Well

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 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. As with many other companies Hubei Zhenhua Chemical Co.,Ltd. (SHSE:603067) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hubei Zhenhua ChemicalLtd

How Much Debt Does Hubei Zhenhua ChemicalLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Hubei Zhenhua ChemicalLtd had CN¥1.25b of debt, an increase on CN¥957.8m, over one year. However, because it has a cash reserve of CN¥435.0m, its net debt is less, at about CN¥815.2m.

How Healthy Is Hubei Zhenhua ChemicalLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hubei Zhenhua ChemicalLtd had liabilities of CN¥654.0m due within 12 months and liabilities of CN¥1.13b due beyond that. Offsetting these obligations, it had cash of CN¥435.0m as well as receivables valued at CN¥869.7m due within 12 months. So its liabilities total CN¥479.3m more than the combination of its cash and short-term receivables.

Given Hubei Zhenhua ChemicalLtd has a market capitalization of CN¥5.98b, 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hubei Zhenhua ChemicalLtd has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 17.5 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Hubei Zhenhua ChemicalLtd grew its EBIT by 6.8% in the last year, making that debt load look even more manageable. 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'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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Hubei Zhenhua ChemicalLtd reported free cash flow worth 12% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish 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. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. When we consider all the elements mentioned above, it seems to us that Hubei Zhenhua ChemicalLtd is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Be aware that Hubei Zhenhua ChemicalLtd is showing 1 warning sign in our investment analysis , you should know about...

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.