The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Ningbo Changhong Polymer Scientific and Technical Inc. (SHSE:605008) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Ningbo Changhong Polymer Scientific and Technical's Debt?

As you can see below, at the end of March 2024, Ningbo Changhong Polymer Scientific and Technical had CN¥2.13b of debt, up from CN¥1.40b a year ago. Click the image for more detail. However, it also had CN¥308.7m in cash, and so its net debt is CN¥1.82b.

A Look At Ningbo Changhong Polymer Scientific and Technical's Liabilities

We can see from the most recent balance sheet that Ningbo Changhong Polymer Scientific and Technical had liabilities of CN¥1.68b falling due within a year, and liabilities of CN¥974.7m due beyond that. Offsetting this, it had CN¥308.7m in cash and CN¥528.9m in receivables that were due within 12 months. So it has liabilities totalling CN¥1.82b more than its cash and near-term receivables, combined.

Ningbo Changhong Polymer Scientific and Technical has a market capitalization of CN¥7.89b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Ningbo Changhong Polymer Scientific and Technical shareholders face the double whammy of a high net debt to EBITDA ratio (12.2), and fairly weak interest coverage, since EBIT is just 0.21 times the interest expense. The debt burden here is substantial. Even worse, Ningbo Changhong Polymer Scientific and Technical saw its EBIT tank 94% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Ningbo Changhong Polymer Scientific and Technical'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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Ningbo Changhong Polymer Scientific and Technical burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Ningbo Changhong Polymer Scientific and Technical's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. We're quite clear that we consider Ningbo Changhong Polymer Scientific and Technical to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 4 warning signs we've spotted with Ningbo Changhong Polymer Scientific and Technical (including 2 which are significant) .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.

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