China BlueChemical (HKG:3983) Could Easily Take On More Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that China BlueChemical Ltd. (HKG:3983) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for China BlueChemical

What Is China BlueChemical's Net Debt?

As you can see below, at the end of December 2022, China BlueChemical had CN¥2.05b of debt, up from CN¥1.02b a year ago. Click the image for more detail. But it also has CN¥13.0b in cash to offset that, meaning it has CN¥11.0b net cash.

A Look At China BlueChemical's Liabilities

According to the last reported balance sheet, China BlueChemical had liabilities of CN¥4.10b due within 12 months, and liabilities of CN¥1.62b due beyond 12 months. On the other hand, it had cash of CN¥13.0b and CN¥597.0m worth of receivables due within a year. So it can boast CN¥7.90b more liquid assets than total liabilities.

This surplus liquidity suggests that China BlueChemical's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, China BlueChemical boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that China BlueChemical has seen its EBIT plunge 18% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China BlueChemical's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While China BlueChemical 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 most recent three years, China BlueChemical recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, the bottom line is that China BlueChemical has net cash of CN¥11.0b and plenty of liquid assets. And it impressed us with free cash flow of CN¥803m, being 75% of its EBIT. So we don't think China BlueChemical's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for China BlueChemical you should be aware of.

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.

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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.