Is North Huajin Chemical IndustriesLtd (SZSE:000059) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 North Huajin Chemical Industries Co.,Ltd (SZSE:000059) makes use of debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

See our latest analysis for North Huajin Chemical IndustriesLtd

What Is North Huajin Chemical IndustriesLtd's Net Debt?

The chart below, which you can click on for greater detail, shows that North Huajin Chemical IndustriesLtd had CN¥11.1b in debt in March 2024; about the same as the year before. However, it does have CN¥5.14b in cash offsetting this, leading to net debt of about CN¥5.96b.

A Look At North Huajin Chemical IndustriesLtd's Liabilities

The latest balance sheet data shows that North Huajin Chemical IndustriesLtd had liabilities of CN¥3.09b due within a year, and liabilities of CN¥10.4b falling due after that. Offsetting this, it had CN¥5.14b in cash and CN¥915.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.42b.

Given this deficit is actually higher than the company's market capitalization of CN¥6.22b, we think shareholders really should watch North Huajin Chemical IndustriesLtd's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.

While North Huajin Chemical IndustriesLtd's debt to EBITDA ratio (3.4) suggests that it uses some debt, its interest cover is very weak, at 1.2, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. On a lighter note, we note that North Huajin Chemical IndustriesLtd grew its EBIT by 29% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. 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 North Huajin Chemical IndustriesLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept 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, North Huajin Chemical IndustriesLtd recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

While North Huajin Chemical IndustriesLtd's interest cover has us nervous. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that North Huajin Chemical IndustriesLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for North Huajin Chemical IndustriesLtd (1 doesn't sit too well with us) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.