David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Hubei Dinglong CO.,Ltd. (SZSE:300054) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Hubei DinglongLtd's Debt?

As you can see below, at the end of September 2024, Hubei DinglongLtd had CN¥1.35b of debt, up from CN¥897.8m a year ago. Click the image for more detail. However, it also had CN¥1.10b in cash, and so its net debt is CN¥253.1m.

How Strong Is Hubei DinglongLtd's Balance Sheet?

We can see from the most recent balance sheet that Hubei DinglongLtd had liabilities of CN¥1.35b falling due within a year, and liabilities of CN¥1.16b due beyond that. Offsetting this, it had CN¥1.10b in cash and CN¥1.09b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥324.5m.

This state of affairs indicates that Hubei DinglongLtd's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥24.5b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Hubei DinglongLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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).

Hubei DinglongLtd's net debt is only 0.35 times its EBITDA. And its EBIT covers its interest expense a whopping 22.7 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Hubei DinglongLtd grew its EBIT by 98% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hubei DinglongLtd'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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, Hubei DinglongLtd 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

Happily, Hubei DinglongLtd's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. When we consider the range of factors above, it looks like Hubei DinglongLtd is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Hubei DinglongLtd's earnings per share history for free.

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.