Is Milkyway Chemical Supply Chain ServiceLtd (SHSE:603713) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Milkyway Chemical Supply Chain Service Co.,Ltd (SHSE:603713) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Milkyway Chemical Supply Chain ServiceLtd

What Is Milkyway Chemical Supply Chain ServiceLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Milkyway Chemical Supply Chain ServiceLtd had debt of CN¥4.05b, up from CN¥2.27b in one year. On the flip side, it has CN¥1.52b in cash leading to net debt of about CN¥2.53b.

A Look At Milkyway Chemical Supply Chain ServiceLtd's Liabilities

According to the last reported balance sheet, Milkyway Chemical Supply Chain ServiceLtd had liabilities of CN¥5.37b due within 12 months, and liabilities of CN¥1.94b due beyond 12 months. On the other hand, it had cash of CN¥1.52b and CN¥3.32b worth of receivables due within a year. So it has liabilities totalling CN¥2.47b more than its cash and near-term receivables, combined.

Milkyway Chemical Supply Chain ServiceLtd has a market capitalization of CN¥8.02b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

With net debt to EBITDA of 2.7 Milkyway Chemical Supply Chain ServiceLtd has a fairly noticeable amount of debt. But the high interest coverage of 7.8 suggests it can easily service that debt. Unfortunately, Milkyway Chemical Supply Chain ServiceLtd saw its EBIT slide 6.8% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, 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

Mulling over Milkyway Chemical Supply Chain ServiceLtd's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Milkyway Chemical Supply Chain ServiceLtd stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 is concerning) you should be aware of.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.