Here's Why Hangzhou Oxygen Plant GroupLtd (SZSE:002430) Has A Meaningful Debt Burden

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.' 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 Hangzhou Oxygen Plant Group Co.,Ltd. (SZSE:002430) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Hangzhou Oxygen Plant GroupLtd

How Much Debt Does Hangzhou Oxygen Plant GroupLtd Carry?

As you can see below, at the end of June 2024, Hangzhou Oxygen Plant GroupLtd had CN¥6.56b of debt, up from CN¥5.11b a year ago. Click the image for more detail. On the flip side, it has CN¥2.44b in cash leading to net debt of about CN¥4.12b.

A Look At Hangzhou Oxygen Plant GroupLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Hangzhou Oxygen Plant GroupLtd had liabilities of CN¥8.20b due within 12 months and liabilities of CN¥4.62b due beyond that. On the other hand, it had cash of CN¥2.44b and CN¥3.90b worth of receivables due within a year. So its liabilities total CN¥6.48b more than the combination of its cash and short-term receivables.

Hangzhou Oxygen Plant GroupLtd has a market capitalization of CN¥16.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Hangzhou Oxygen Plant GroupLtd's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its commanding EBIT of 24.3 times its interest expense, implies the debt load is as light as a peacock feather. We saw Hangzhou Oxygen Plant GroupLtd grow its EBIT by 5.0% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hangzhou Oxygen Plant GroupLtd 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hangzhou Oxygen Plant GroupLtd 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

Hangzhou Oxygen Plant GroupLtd's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Hangzhou Oxygen Plant GroupLtd 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Hangzhou Oxygen Plant GroupLtd .

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.