Liaoning Dingjide Petrochemical (SHSE:603255) Takes On Some Risk With Its Use Of 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 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 Liaoning Dingjide Petrochemical Co., Ltd. (SHSE:603255) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Liaoning Dingjide Petrochemical

What Is Liaoning Dingjide Petrochemical's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Liaoning Dingjide Petrochemical had debt of CN¥618.3m, up from CN¥191.6m in one year. However, it does have CN¥205.4m in cash offsetting this, leading to net debt of about CN¥412.9m.

How Strong Is Liaoning Dingjide Petrochemical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Liaoning Dingjide Petrochemical had liabilities of CN¥780.0m due within 12 months and liabilities of CN¥81.1m due beyond that. Offsetting this, it had CN¥205.4m in cash and CN¥378.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥277.4m.

Since publicly traded Liaoning Dingjide Petrochemical shares are worth a total of CN¥3.83b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

Liaoning Dingjide Petrochemical has a rather high debt to EBITDA ratio of 5.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 5.4 times, suggesting it can responsibly service its obligations. Importantly, Liaoning Dingjide Petrochemical's EBIT fell a jaw-dropping 78% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is Liaoning Dingjide Petrochemical's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last three years, Liaoning Dingjide Petrochemical 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

On the face of it, Liaoning Dingjide Petrochemical's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Overall, we think it's fair to say that Liaoning Dingjide Petrochemical has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 Liaoning Dingjide Petrochemical has 3 warning signs (and 2 which don't sit too well with us) we think 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.