Is Milkyway Chemical Supply Chain ServiceLtd (SHSE:603713) A Risky Investment?

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 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 Milkyway Chemical Supply Chain Service Co.,Ltd (SHSE:603713) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Milkyway Chemical Supply Chain ServiceLtd

How Much Debt Does Milkyway Chemical Supply Chain ServiceLtd Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Milkyway Chemical Supply Chain ServiceLtd had debt of CN¥4.65b, up from CN¥3.20b in one year. However, it does have CN¥1.51b in cash offsetting this, leading to net debt of about CN¥3.14b.

How Healthy Is Milkyway Chemical Supply Chain ServiceLtd's Balance Sheet?

We can see from the most recent balance sheet that Milkyway Chemical Supply Chain ServiceLtd had liabilities of CN¥5.17b falling due within a year, and liabilities of CN¥2.08b due beyond that. Offsetting this, it had CN¥1.51b in cash and CN¥3.79b in receivables that were due within 12 months. So its liabilities total CN¥1.95b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Milkyway Chemical Supply Chain ServiceLtd has a market capitalization of CN¥7.48b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Milkyway Chemical Supply Chain ServiceLtd has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 6.6 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. One way Milkyway Chemical Supply Chain ServiceLtd could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Milkyway Chemical Supply Chain ServiceLtd'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Milkyway Chemical Supply Chain ServiceLtd 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

Milkyway Chemical Supply Chain ServiceLtd'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 grow its EBIT isn't too shabby at all. We think that Milkyway Chemical Supply Chain ServiceLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 instance, we've identified 2 warning signs for Milkyway Chemical Supply Chain ServiceLtd (1 can't be ignored) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.