These 4 Measures Indicate That Dongguang Chemical (HKG:1702) Is Using Debt Reasonably Well

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Dongguang Chemical Limited (HKG:1702) makes use of debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Dongguang Chemical

How Much Debt Does Dongguang Chemical Carry?

The image below, which you can click on for greater detail, shows that Dongguang Chemical had debt of CN¥373.0m at the end of June 2020, a reduction from CN¥589.7m over a year. But it also has CN¥419.1m in cash to offset that, meaning it has CN¥46.1m net cash.

How Strong Is Dongguang Chemical's Balance Sheet?

According to the last reported balance sheet, Dongguang Chemical had liabilities of CN¥537.0m due within 12 months, and liabilities of CN¥36.6m due beyond 12 months. On the other hand, it had cash of CN¥419.1m and CN¥55.7m worth of receivables due within a year. So its liabilities total CN¥98.8m more than the combination of its cash and short-term receivables.

Given Dongguang Chemical has a market capitalization of CN¥775.4m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Dongguang Chemical boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Dongguang Chemical's load is not too heavy, because its EBIT was down 32% 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 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, 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. Over the last three years, Dongguang Chemical actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

Although Dongguang Chemical's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥46.1m. And it impressed us with free cash flow of CN¥249m, being 147% of its EBIT. 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. However, not all investment risk resides within the balance sheet - far from it. Consider risks, for instance. Every company has them, and we've spotted 1 warning sign for Dongguang Chemical you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

If you decide to trade Dongguang Chemical, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

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