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. We can see that Shandong Hualu-Hengsheng Chemical Co., Ltd. (SHSE:600426) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Shandong Hualu-Hengsheng Chemical's Net Debt?

As you can see below, at the end of March 2024, Shandong Hualu-Hengsheng Chemical had CN¥8.29b of debt, up from CN¥4.68b a year ago. Click the image for more detail. However, it also had CN¥2.20b in cash, and so its net debt is CN¥6.09b.

A Look At Shandong Hualu-Hengsheng Chemical's Liabilities

Zooming in on the latest balance sheet data, we can see that Shandong Hualu-Hengsheng Chemical had liabilities of CN¥5.34b due within 12 months and liabilities of CN¥8.01b due beyond that. On the other hand, it had cash of CN¥2.20b and CN¥2.86b worth of receivables due within a year. So it has liabilities totalling CN¥8.29b more than its cash and near-term receivables, combined.

Of course, Shandong Hualu-Hengsheng Chemical has a market capitalization of CN¥62.4b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Shandong Hualu-Hengsheng Chemical's net debt is only 0.88 times its EBITDA. And its EBIT easily covers its interest expense, being 41.6 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Shandong Hualu-Hengsheng Chemical's EBIT dived 11%, over the last year. 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 Shandong Hualu-Hengsheng Chemical'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shandong Hualu-Hengsheng Chemical recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Shandong Hualu-Hengsheng Chemical's conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We think that Shandong Hualu-Hengsheng Chemical's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Shandong Hualu-Hengsheng Chemical (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.