Is Hangzhou Oxygen Plant GroupLtd (SZSE:002430) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We note that Hangzhou Oxygen Plant Group Co.,Ltd. (SZSE:002430) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hangzhou Oxygen Plant GroupLtd

What Is Hangzhou Oxygen Plant GroupLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Hangzhou Oxygen Plant GroupLtd had CN¥6.28b of debt, an increase on CN¥4.65b, over one year. On the flip side, it has CN¥3.25b in cash leading to net debt of about CN¥3.03b.

A Look At Hangzhou Oxygen Plant GroupLtd's Liabilities

The latest balance sheet data shows that Hangzhou Oxygen Plant GroupLtd had liabilities of CN¥8.78b due within a year, and liabilities of CN¥3.89b falling due after that. On the other hand, it had cash of CN¥3.25b and CN¥4.23b worth of receivables due within a year. So it has liabilities totalling CN¥5.19b more than its cash and near-term receivables, combined.

Hangzhou Oxygen Plant GroupLtd has a market capitalization of CN¥25.8b, so it could very likely raise cash to ameliorate 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.

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.

Hangzhou Oxygen Plant GroupLtd's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 21.3 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Hangzhou Oxygen Plant GroupLtd saw its EBIT drop by 6.1% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Hangzhou Oxygen Plant GroupLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Hangzhou Oxygen Plant GroupLtd's conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Hangzhou Oxygen Plant GroupLtd's debt does make it a bit risky, after considering the aforementioned data points together. 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. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Hangzhou Oxygen Plant GroupLtd , and understanding them should be part of your investment process.

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.