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.' 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. As with many other companies Milkyway Chemical Supply Chain Service Co.,Ltd (SHSE:603713) makes use of debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Milkyway Chemical Supply Chain ServiceLtd

What Is Milkyway Chemical Supply Chain ServiceLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Milkyway Chemical Supply Chain ServiceLtd had debt of CN¥5.01b, up from CN¥4.05b in one year. However, it does have CN¥1.50b in cash offsetting this, leading to net debt of about CN¥3.51b.

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¥5.43b falling due within a year, and liabilities of CN¥2.28b due beyond that. Offsetting this, it had CN¥1.50b in cash and CN¥4.21b in receivables that were due within 12 months. So its liabilities total CN¥2.01b 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¥7.95b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

Milkyway Chemical Supply Chain ServiceLtd's debt is 3.6 times its EBITDA, and its EBIT cover its interest expense 6.1 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Milkyway Chemical Supply Chain ServiceLtd grew its EBIT by 7.2% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to 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 Milkyway Chemical Supply Chain ServiceLtd 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Milkyway Chemical Supply Chain ServiceLtd 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

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. Taking the abovementioned factors together we do think Milkyway Chemical Supply Chain ServiceLtd's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Milkyway Chemical Supply Chain ServiceLtd is showing 2 warning signs in our investment analysis , and 1 of those is a bit concerning...

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.