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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Hubei Huitian New Materials Co., Ltd. (SZSE:300041) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.

What Is Hubei Huitian New Materials's Net Debt?

As you can see below, at the end of September 2024, Hubei Huitian New Materials had CN¥1.96b of debt, up from CN¥1.47b a year ago. Click the image for more detail. However, it also had CN¥972.9m in cash, and so its net debt is CN¥990.1m.

A Look At Hubei Huitian New Materials' Liabilities

According to the last reported balance sheet, Hubei Huitian New Materials had liabilities of CN¥2.52b due within 12 months, and liabilities of CN¥1.04b due beyond 12 months. On the other hand, it had cash of CN¥972.9m and CN¥1.91b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥666.8m.

Of course, Hubei Huitian New Materials has a market capitalization of CN¥5.40b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

Hubei Huitian New Materials has a debt to EBITDA ratio of 3.8 and its EBIT covered its interest expense 5.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, Hubei Huitian New Materials's EBIT fell a jaw-dropping 55% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Hubei Huitian New Materials 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Hubei Huitian New Materials's free cash flow amounted to 22% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Hubei Huitian New Materials's EBIT growth rate was disappointing. But at least its level of total liabilities is not so bad. Once we consider all the factors above, together, it seems to us that Hubei Huitian New Materials's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that Hubei Huitian New Materials is showing 3 warning signs in our investment analysis , 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.