These 4 Measures Indicate That Guizhou Chanhen Chemical (SZSE:002895) Is Using Debt Extensively

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Guizhou Chanhen Chemical Corporation (SZSE:002895) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Guizhou Chanhen Chemical

What Is Guizhou Chanhen Chemical's Debt?

As you can see below, at the end of December 2023, Guizhou Chanhen Chemical had CN¥3.85b of debt, up from CN¥3.49b a year ago. Click the image for more detail. However, it does have CN¥2.25b in cash offsetting this, leading to net debt of about CN¥1.60b.

A Look At Guizhou Chanhen Chemical's Liabilities

According to the last reported balance sheet, Guizhou Chanhen Chemical had liabilities of CN¥2.94b due within 12 months, and liabilities of CN¥2.76b due beyond 12 months. Offsetting this, it had CN¥2.25b in cash and CN¥862.1m in receivables that were due within 12 months. So its liabilities total CN¥2.59b 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¥10.8b, 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Guizhou Chanhen Chemical has net debt of just 1.1 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.5 times the interest expense over the last year. Fortunately, Guizhou Chanhen Chemical grew its EBIT by 4.9% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Guizhou Chanhen Chemical 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

Guizhou Chanhen Chemical's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that Guizhou Chanhen Chemical is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 2 warning signs for Guizhou Chanhen Chemical that you should be aware of before investing here.

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.