Here's Why Rongsheng Petrochemical (SZSE:002493) Is Weighed Down By Its Debt Load

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.' 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 note that Rongsheng Petrochemical Co., Ltd. (SZSE:002493) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Rongsheng Petrochemical

How Much Debt Does Rongsheng Petrochemical Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Rongsheng Petrochemical had debt of CN¥210.3b, up from CN¥202.2b in one year. On the flip side, it has CN¥22.4b in cash leading to net debt of about CN¥187.9b.

How Strong Is Rongsheng Petrochemical's Balance Sheet?

We can see from the most recent balance sheet that Rongsheng Petrochemical had liabilities of CN¥153.0b falling due within a year, and liabilities of CN¥132.3b due beyond that. On the other hand, it had cash of CN¥22.4b and CN¥9.08b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥253.9b.

The deficiency here weighs heavily on the CN¥99.0b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Rongsheng Petrochemical would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Weak interest cover of 2.3 times and a disturbingly high net debt to EBITDA ratio of 6.2 hit our confidence in Rongsheng Petrochemical like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for Rongsheng Petrochemical is that it turned last year's EBIT loss into a gain of CN¥15b, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Rongsheng Petrochemical's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Rongsheng Petrochemical produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, Rongsheng Petrochemical's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. We're quite clear that we consider Rongsheng Petrochemical to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that Rongsheng Petrochemical is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

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.