Is Zhejiang Xinhua ChemicalLtd (SHSE:603867) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Zhejiang Xinhua Chemical Co.,Ltd (SHSE:603867) does use debt in its business. But should shareholders be worried about its use of debt?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Zhejiang Xinhua ChemicalLtd

How Much Debt Does Zhejiang Xinhua ChemicalLtd Carry?

As you can see below, at the end of September 2024, Zhejiang Xinhua ChemicalLtd had CN¥753.8m of debt, up from CN¥658.7m a year ago. Click the image for more detail. On the flip side, it has CN¥573.2m in cash leading to net debt of about CN¥180.6m.

A Look At Zhejiang Xinhua ChemicalLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Zhejiang Xinhua ChemicalLtd had liabilities of CN¥757.5m due within 12 months and liabilities of CN¥880.9m due beyond that. Offsetting these obligations, it had cash of CN¥573.2m as well as receivables valued at CN¥808.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥256.9m.

Given Zhejiang Xinhua ChemicalLtd has a market capitalization of CN¥4.94b, 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.

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

Zhejiang Xinhua ChemicalLtd's net debt is only 0.44 times its EBITDA. And its EBIT covers its interest expense a whopping 18.8 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Zhejiang Xinhua ChemicalLtd's EBIT dived 14%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But it is Zhejiang Xinhua ChemicalLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Zhejiang Xinhua ChemicalLtd burned a lot of cash. 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 Zhejiang Xinhua ChemicalLtd's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. For example, its interest cover and net debt to EBITDA give us some confidence in its ability to manage its debt. We think that Zhejiang Xinhua ChemicalLtd's debt does make it a bit risky, after considering the aforementioned data points together. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Zhejiang Xinhua 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.