Is Guizhou Chanhen Chemical (SZSE:002895) Using Too Much Debt?

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.' 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, Guizhou Chanhen Chemical Corporation (SZSE:002895) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Guizhou Chanhen Chemical

How Much Debt Does Guizhou Chanhen Chemical Carry?

The image below, which you can click on for greater detail, shows that Guizhou Chanhen Chemical had debt of CN¥3.78b at the end of September 2024, a reduction from CN¥4.34b over a year. However, it also had CN¥2.10b in cash, and so its net debt is CN¥1.68b.

How Healthy Is Guizhou Chanhen Chemical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Guizhou Chanhen Chemical had liabilities of CN¥3.13b due within 12 months and liabilities of CN¥2.71b due beyond that. Offsetting this, it had CN¥2.10b in cash and CN¥771.0m in receivables that were due within 12 months. So its liabilities total CN¥2.96b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Guizhou Chanhen Chemical has a market capitalization of CN¥11.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Guizhou Chanhen Chemical's net debt is only 0.95 times its EBITDA. And its EBIT covers its interest expense a whopping 11.3 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Guizhou Chanhen Chemical grew its EBIT by 37% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Guizhou Chanhen Chemical 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Guizhou Chanhen Chemical 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

Guizhou Chanhen Chemical's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to grow its EBIT is pretty flash. Considering this range of data points, we think Guizhou Chanhen Chemical is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Guizhou Chanhen Chemical you should be aware of.

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.