Shandong Sinocera Functional Material (SZSE:300285) Has A Pretty Healthy Balance Sheet

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 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. We note that Shandong Sinocera Functional Material Co., Ltd. (SZSE:300285) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Shandong Sinocera Functional Material

What Is Shandong Sinocera Functional Material's Net Debt?

As you can see below, at the end of June 2024, Shandong Sinocera Functional Material had CN¥605.1m of debt, up from CN¥399.3m a year ago. Click the image for more detail. However, it does have CN¥543.5m in cash offsetting this, leading to net debt of about CN¥61.6m.

How Healthy Is Shandong Sinocera Functional Material's Balance Sheet?

We can see from the most recent balance sheet that Shandong Sinocera Functional Material had liabilities of CN¥1.40b falling due within a year, and liabilities of CN¥554.3m due beyond that. Offsetting these obligations, it had cash of CN¥543.5m as well as receivables valued at CN¥2.32b due within 12 months. So it actually has CN¥905.2m more liquid assets than total liabilities.

This surplus suggests that Shandong Sinocera Functional Material has a conservative balance sheet, and could probably eliminate its debt without much difficulty. But either way, Shandong Sinocera Functional Material has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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).

Shandong Sinocera Functional Material has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.064 and EBIT of 98.9 times the interest expense. So relative to past earnings, the debt load seems trivial. On top of that, Shandong Sinocera Functional Material grew its EBIT by 48% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shandong Sinocera Functional Material'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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shandong Sinocera Functional Material recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Happily, Shandong Sinocera Functional Material's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at the bigger picture, we think Shandong Sinocera Functional Material's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Over time, share prices tend to follow earnings per share, so if you're interested in Shandong Sinocera Functional Material, you may well want to click here to check an interactive graph of its earnings per share history.

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.