Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We can see that Jiangsu ChengXing Phosph-Chemicals Co., Ltd. (SHSE:600078) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Jiangsu ChengXing Phosph-Chemicals Carry?

As you can see below, Jiangsu ChengXing Phosph-Chemicals had CN¥1.65b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥449.3m in cash leading to net debt of about CN¥1.20b.

How Strong Is Jiangsu ChengXing Phosph-Chemicals' Balance Sheet?

According to the last reported balance sheet, Jiangsu ChengXing Phosph-Chemicals had liabilities of CN¥1.51b due within 12 months, and liabilities of CN¥1.56b due beyond 12 months. Offsetting these obligations, it had cash of CN¥449.3m as well as receivables valued at CN¥949.3m due within 12 months. So its liabilities total CN¥1.67b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Jiangsu ChengXing Phosph-Chemicals has a market capitalization of CN¥4.10b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

While Jiangsu ChengXing Phosph-Chemicals's debt to EBITDA ratio (4.0) suggests that it uses some debt, its interest cover is very weak, at 1.7, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. One redeeming factor for Jiangsu ChengXing Phosph-Chemicals is that it turned last year's EBIT loss into a gain of CN¥34m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Jiangsu ChengXing Phosph-Chemicals's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Jiangsu ChengXing Phosph-Chemicals actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

When it comes to the balance sheet, the standout positive for Jiangsu ChengXing Phosph-Chemicals was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. Looking at all this data makes us feel a little cautious about Jiangsu ChengXing Phosph-Chemicals's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Jiangsu ChengXing Phosph-Chemicals you should know about.

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.