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 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 Rongsheng Petrochemical Co., Ltd. (SZSE:002493) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Rongsheng Petrochemical's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Rongsheng Petrochemical had CN¥210.3b of debt, an increase on CN¥202.2b, over one year. However, it does have CN¥22.4b in cash offsetting this, leading to net debt of about CN¥187.9b.

How Healthy Is Rongsheng Petrochemical's Balance Sheet?

According to the last reported balance sheet, Rongsheng Petrochemical had liabilities of CN¥153.0b due within 12 months, and liabilities of CN¥132.3b due beyond 12 months. Offsetting this, it had CN¥22.4b in cash and CN¥9.08b in receivables that were due within 12 months. So it has liabilities totalling CN¥253.9b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥92.4b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Rongsheng Petrochemical would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 2.3 times and a disturbingly high net debt to EBITDA ratio of 6.2 hit our confidence in Rongsheng Petrochemical like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for Rongsheng Petrochemical is that it turned last year's EBIT loss into a gain of CN¥15b, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Rongsheng Petrochemical can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Rongsheng Petrochemical produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Rongsheng Petrochemical's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. We're quite clear that we consider Rongsheng Petrochemical to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Rongsheng Petrochemical (1 is significant!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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