Shandong Sinocera Functional Material (SZSE:300285) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Shandong Sinocera Functional Material Co., Ltd. (SZSE:300285) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 Debt?

As you can see below, at the end of September 2024, Shandong Sinocera Functional Material had CN¥670.4m of debt, up from CN¥440.0m a year ago. Click the image for more detail. On the flip side, it has CN¥550.4m in cash leading to net debt of about CN¥120.0m.

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

The latest balance sheet data shows that Shandong Sinocera Functional Material had liabilities of CN¥1.54b due within a year, and liabilities of CN¥597.9m falling due after that. On the other hand, it had cash of CN¥550.4m and CN¥2.26b worth of receivables due within a year. So it can boast CN¥669.6m more liquid assets than total liabilities.

This short term liquidity is a sign that Shandong Sinocera Functional Material could probably pay off its debt with ease, as its balance sheet is far from stretched. 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!

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shandong Sinocera Functional Material has a low net debt to EBITDA ratio of only 0.12. And its EBIT easily covers its interest expense, being 103 times the size. So we're pretty relaxed about its super-conservative use of debt. Also positive, Shandong Sinocera Functional Material grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, 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

Shandong Sinocera Functional Material's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that Shandong Sinocera Functional Material takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. For example - Shandong Sinocera Functional Material has 1 warning sign we think you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.