Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. Importantly, Hunan Valin Steel Co., Ltd. (SZSE:000932) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Hunan Valin Steel's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Hunan Valin Steel had CN¥21.3b of debt, an increase on CN¥15.7b, over one year. However, it does have CN¥7.37b in cash offsetting this, leading to net debt of about CN¥13.9b.

How Healthy Is Hunan Valin Steel's Balance Sheet?

The latest balance sheet data shows that Hunan Valin Steel had liabilities of CN¥51.3b due within a year, and liabilities of CN¥16.3b falling due after that. On the other hand, it had cash of CN¥7.37b and CN¥16.1b worth of receivables due within a year. So it has liabilities totalling CN¥44.1b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥39.0b, we think shareholders really should watch Hunan Valin Steel's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hunan Valin Steel has a low debt to EBITDA ratio of only 1.3. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. On the other hand, Hunan Valin Steel's EBIT dived 19%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hunan Valin Steel's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Hunan Valin Steel produced sturdy free cash flow equating to 52% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Mulling over Hunan Valin Steel's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Hunan Valin Steel's debt is making it 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. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Hunan Valin Steel you should be aware of.

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.

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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.