We Think Wuzhou Special Paper Group (SHSE:605007) Is Taking Some Risk With Its 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Wuzhou Special Paper Group Co., Ltd. (SHSE:605007) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

Check out our latest analysis for Wuzhou Special Paper Group

How Much Debt Does Wuzhou Special Paper Group Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Wuzhou Special Paper Group had debt of CN¥5.11b, up from CN¥3.29b in one year. However, because it has a cash reserve of CN¥499.6m, its net debt is less, at about CN¥4.61b.

How Healthy Is Wuzhou Special Paper Group's Balance Sheet?

The latest balance sheet data shows that Wuzhou Special Paper Group had liabilities of CN¥4.21b due within a year, and liabilities of CN¥2.74b falling due after that. On the other hand, it had cash of CN¥499.6m and CN¥1.32b worth of receivables due within a year. So its liabilities total CN¥5.13b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥5.55b, so it does suggest shareholders should keep an eye on Wuzhou Special Paper Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

As it happens Wuzhou Special Paper Group has a fairly concerning net debt to EBITDA ratio of 5.2 but very strong interest coverage of 28.5. So either it has access to very cheap long term debt or that interest expense is going to grow! Pleasingly, Wuzhou Special Paper Group is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 311% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Wuzhou Special Paper Group 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Wuzhou Special Paper Group 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

While Wuzhou Special Paper Group's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Wuzhou Special Paper Group's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Wuzhou Special Paper Group is showing 3 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

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.