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. As with many other companies Qingdao Kingking Applied Chemistry Co., Ltd. (SZSE:002094) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Qingdao Kingking Applied Chemistry's Net Debt?

The chart below, which you can click on for greater detail, shows that Qingdao Kingking Applied Chemistry had CN¥1.17b in debt in September 2024; about the same as the year before. However, because it has a cash reserve of CN¥665.9m, its net debt is less, at about CN¥501.0m.

How Strong Is Qingdao Kingking Applied Chemistry's Balance Sheet?

We can see from the most recent balance sheet that Qingdao Kingking Applied Chemistry had liabilities of CN¥1.94b falling due within a year, and liabilities of CN¥8.71m due beyond that. On the other hand, it had cash of CN¥665.9m and CN¥588.0m worth of receivables due within a year. So its liabilities total CN¥690.7m more than the combination of its cash and short-term receivables.

Of course, Qingdao Kingking Applied Chemistry has a market capitalization of CN¥4.33b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Qingdao Kingking Applied Chemistry has a debt to EBITDA ratio of 4.7, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We also note that Qingdao Kingking Applied Chemistry improved its EBIT from a last year's loss to a positive CN¥82m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Qingdao Kingking Applied Chemistry's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Qingdao Kingking Applied Chemistry saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Qingdao Kingking Applied Chemistry's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Qingdao Kingking Applied Chemistry is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. To that end, you should be aware of the 1 warning sign we've spotted with Qingdao Kingking Applied Chemistry .

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.