Is Dongguang Chemical (HKG:1702) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Dongguang Chemical Limited (HKG:1702) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Dongguang Chemical

What Is Dongguang Chemical's Debt?

As you can see below, at the end of June 2021, Dongguang Chemical had CN¥399.1m of debt, up from CN¥373.0m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥717.7m in cash, so it actually has CN¥318.6m net cash.

How Healthy Is Dongguang Chemical's Balance Sheet?

The latest balance sheet data shows that Dongguang Chemical had liabilities of CN¥634.2m due within a year, and liabilities of CN¥33.6m falling due after that. Offsetting this, it had CN¥717.7m in cash and CN¥43.0m in receivables that were due within 12 months. So it can boast CN¥92.9m more liquid assets than total liabilities.

This short term liquidity is a sign that Dongguang Chemical could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Dongguang Chemical boasts net cash, so it's fair to say it does not have a heavy debt load!

On top of that, Dongguang Chemical grew its EBIT by 66% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Dongguang Chemical will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 it is always sensible to investigate a company's debt, in this case Dongguang Chemical has CN¥318.6m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 120% of that EBIT to free cash flow, bringing in CN¥245m. So we don't think Dongguang Chemical's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Dongguang Chemical , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.

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