Anhui Honglu Steel Construction(Group) (SZSE:002541) Seems To Be Using A Lot Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Anhui Honglu Steel Construction(Group) CO., LTD (SZSE:002541) does carry 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Anhui Honglu Steel Construction(Group)

What Is Anhui Honglu Steel Construction(Group)'s Net Debt?

As you can see below, at the end of September 2023, Anhui Honglu Steel Construction(Group) had CN¥7.55b of debt, up from CN¥5.72b a year ago. Click the image for more detail. However, it does have CN¥1.46b in cash offsetting this, leading to net debt of about CN¥6.09b.

A Look At Anhui Honglu Steel Construction(Group)'s Liabilities

The latest balance sheet data shows that Anhui Honglu Steel Construction(Group) had liabilities of CN¥7.82b due within a year, and liabilities of CN¥6.10b falling due after that. Offsetting these obligations, it had cash of CN¥1.46b as well as receivables valued at CN¥2.63b due within 12 months. So it has liabilities totalling CN¥9.84b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥12.3b, so it does suggest shareholders should keep an eye on Anhui Honglu Steel Construction(Group)'s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Anhui Honglu Steel Construction(Group)'s debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 4.2 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Another concern for investors might be that Anhui Honglu Steel Construction(Group)'s EBIT fell 18% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Anhui Honglu Steel Construction(Group)'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, 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. Over the last three years, Anhui Honglu Steel Construction(Group) 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

To be frank both Anhui Honglu Steel Construction(Group)'s EBIT growth rate and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And even its level of total liabilities fails to inspire much confidence. We're quite clear that we consider Anhui Honglu Steel Construction(Group) to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Anhui Honglu Steel Construction(Group) (of which 1 shouldn't be ignored!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.