Ningbo Changhong Polymer Scientific and Technical (SHSE:605008) Use Of Debt Could Be Considered Risky

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.' 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. We can see that Ningbo Changhong Polymer Scientific and Technical Inc. (SHSE:605008) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Ningbo Changhong Polymer Scientific and Technical

What Is Ningbo Changhong Polymer Scientific and Technical's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Ningbo Changhong Polymer Scientific and Technical had debt of CN¥1.70b, up from CN¥1.48b in one year. However, because it has a cash reserve of CN¥297.3m, its net debt is less, at about CN¥1.40b.

How Healthy Is Ningbo Changhong Polymer Scientific and Technical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ningbo Changhong Polymer Scientific and Technical had liabilities of CN¥1.69b due within 12 months and liabilities of CN¥607.0m due beyond that. Offsetting this, it had CN¥297.3m in cash and CN¥632.8m in receivables that were due within 12 months. So its liabilities total CN¥1.37b more than the combination of its cash and short-term receivables.

Of course, Ningbo Changhong Polymer Scientific and Technical has a market capitalization of CN¥8.99b, so these liabilities are probably manageable. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.14 times and a disturbingly high net debt to EBITDA ratio of 7.8 hit our confidence in Ningbo Changhong Polymer Scientific and Technical like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Ningbo Changhong Polymer Scientific and Technical saw its EBIT tank 98% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Ningbo Changhong Polymer Scientific and Technical will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. During the last three years, Ningbo Changhong Polymer Scientific and Technical 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

On the face of it, Ningbo Changhong Polymer Scientific and Technical'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. Having said that, its ability to handle its total liabilities isn't such a worry. We're quite clear that we consider Ningbo Changhong Polymer Scientific and Technical to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example, we've discovered 3 warning signs for Ningbo Changhong Polymer Scientific and Technical (2 are significant!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.