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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Jiangsu Dingsheng New Materials Joint-Stock Co.,Ltd (SHSE:603876) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Jiangsu Dingsheng New Materials Ltd's Debt?

The chart below, which you can click on for greater detail, shows that Jiangsu Dingsheng New Materials Ltd had CN¥7.11b in debt in March 2024; about the same as the year before. However, it does have CN¥6.76b in cash offsetting this, leading to net debt of about CN¥349.9m.

How Strong Is Jiangsu Dingsheng New Materials Ltd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Jiangsu Dingsheng New Materials Ltd had liabilities of CN¥13.8b due within 12 months and liabilities of CN¥3.20b due beyond that. On the other hand, it had cash of CN¥6.76b and CN¥3.76b worth of receivables due within a year. So it has liabilities totalling CN¥6.45b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥8.59b, so it does suggest shareholders should keep an eye on Jiangsu Dingsheng New Materials Ltd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Jiangsu Dingsheng New Materials Ltd's net debt is only 0.33 times its EBITDA. And its EBIT covers its interest expense a whopping 29.1 times over. So we're pretty relaxed about its super-conservative use of debt. In fact Jiangsu Dingsheng New Materials Ltd's saving grace is its low debt levels, because its EBIT has tanked 75% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Jiangsu Dingsheng New Materials Ltd can strengthen its balance sheet over time. 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Jiangsu Dingsheng New Materials Ltd recorded free cash flow worth 57% 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.

Our View

We feel some trepidation about Jiangsu Dingsheng New Materials Ltd's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Jiangsu Dingsheng New Materials Ltd is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Jiangsu Dingsheng New Materials Ltd you should be aware of.

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.