Is Guizhou Chanhen Chemical (SZSE:002895) 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.' 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 Guizhou Chanhen Chemical Corporation (SZSE:002895) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.

See our latest analysis for Guizhou Chanhen Chemical

What Is Guizhou Chanhen Chemical's Debt?

The chart below, which you can click on for greater detail, shows that Guizhou Chanhen Chemical had CN¥4.06b in debt in March 2024; about the same as the year before. However, it does have CN¥2.16b in cash offsetting this, leading to net debt of about CN¥1.90b.

A Look At Guizhou Chanhen Chemical's Liabilities

According to the last reported balance sheet, Guizhou Chanhen Chemical had liabilities of CN¥2.38b due within 12 months, and liabilities of CN¥3.06b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.16b as well as receivables valued at CN¥842.1m due within 12 months. So its liabilities total CN¥2.43b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Guizhou Chanhen Chemical is worth CN¥8.87b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

With net debt sitting at just 1.4 times EBITDA, Guizhou Chanhen Chemical is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.3 times the interest expense over the last year. But the other side of the story is that Guizhou Chanhen Chemical saw its EBIT decline by 7.4% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Guizhou Chanhen Chemical's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Guizhou Chanhen Chemical saw substantial negative free cash flow, in total. 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

Guizhou Chanhen Chemical's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its interest cover is relatively strong. Taking the abovementioned factors together we do think Guizhou Chanhen Chemical's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Guizhou Chanhen Chemical , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.

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