Is Henan Hengxing Science & TechnologyLtd (SZSE:002132) A Risky Investment?

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Henan Hengxing Science & Technology Co.,Ltd. (SZSE:002132) makes use of debt. But the more important question is: how much risk is that debt creating?

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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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Henan Hengxing Science & TechnologyLtd's Net Debt?

As you can see below, Henan Hengxing Science & TechnologyLtd had CN¥2.70b of debt at September 2024, down from CN¥3.03b a year prior. However, it does have CN¥743.8m in cash offsetting this, leading to net debt of about CN¥1.96b.

How Strong Is Henan Hengxing Science & TechnologyLtd's Balance Sheet?

According to the last reported balance sheet, Henan Hengxing Science & TechnologyLtd had liabilities of CN¥3.82b due within 12 months, and liabilities of CN¥690.2m due beyond 12 months. Offsetting this, it had CN¥743.8m in cash and CN¥1.39b in receivables that were due within 12 months. So its liabilities total CN¥2.37b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Henan Hengxing Science & TechnologyLtd is worth CN¥4.67b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

View our latest analysis for Henan Hengxing Science & TechnologyLtd

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). 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).

While we wouldn't worry about Henan Hengxing Science & TechnologyLtd's net debt to EBITDA ratio of 5.0, we think its super-low interest cover of 2.5 times is a sign of 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. However, one redeeming factor is that Henan Hengxing Science & TechnologyLtd grew its EBIT at 12% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Henan Hengxing Science & TechnologyLtd'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Henan Hengxing Science & TechnologyLtd 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

We'd go so far as to say Henan Hengxing Science & TechnologyLtd's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Henan Hengxing Science & TechnologyLtd has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 example Henan Hengxing Science & TechnologyLtd has 4 warning signs (and 1 which is potentially serious) we think 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.