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 Shandong Chenming Paper Holdings Limited (SZSE:000488) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Shandong Chenming Paper Holdings

How Much Debt Does Shandong Chenming Paper Holdings Carry?

The image below, which you can click on for greater detail, shows that Shandong Chenming Paper Holdings had debt of CN¥43.0b at the end of March 2023, a reduction from CN¥45.2b over a year. However, it also had CN¥12.0b in cash, and so its net debt is CN¥31.0b.

A Look At Shandong Chenming Paper Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Shandong Chenming Paper Holdings had liabilities of CN¥50.4b due within 12 months and liabilities of CN¥8.18b due beyond that. Offsetting this, it had CN¥12.0b in cash and CN¥9.76b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥36.8b.

This deficit casts a shadow over the CN¥10.7b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Shandong Chenming Paper Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shandong Chenming Paper Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (8.5), and fairly weak interest coverage, since EBIT is just 0.82 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Shandong Chenming Paper Holdings's EBIT was down 60% over the last year. 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shandong Chenming Paper Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Shandong Chenming Paper Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Shandong Chenming Paper Holdings's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Shandong Chenming Paper Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Shandong Chenming Paper Holdings you should be aware of.

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.