Here's Why Dongguang Chemical (HKG:1702) Can Manage Its Debt Responsibly

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. We note that Dongguang Chemical Limited (HKG:1702) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

See our latest analysis for Dongguang Chemical

What Is Dongguang Chemical's Debt?

You can click the graphic below for the historical numbers, but it shows that Dongguang Chemical had CN¥291.0m of debt in December 2020, down from CN¥442.1m, one year before. But it also has CN¥367.1m in cash to offset that, meaning it has CN¥76.1m net cash.

How Healthy Is Dongguang Chemical's Balance Sheet?

According to the last reported balance sheet, Dongguang Chemical had liabilities of CN¥479.6m due within 12 months, and liabilities of CN¥45.4m due beyond 12 months. Offsetting this, it had CN¥367.1m in cash and CN¥40.8m in receivables that were due within 12 months. So its liabilities total CN¥117.1m more than the combination of its cash and short-term receivables.

Since publicly traded Dongguang Chemical shares are worth a total of CN¥881.8m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Dongguang Chemical also has more cash than debt, so we're pretty confident it can manage its debt safely.

It is just as well that Dongguang Chemical's load is not too heavy, because its EBIT was down 31% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is Dongguang Chemical's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Dongguang Chemical has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Dongguang Chemical actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While Dongguang Chemical does have more liabilities than liquid assets, it also has net cash of CN¥76.1m. The cherry on top was that in converted 147% of that EBIT to free cash flow, bringing in CN¥249m. So we are not troubled with Dongguang Chemical's debt use. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Dongguang Chemical you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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