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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Shandong Humon Smelting Co., Ltd. (SZSE:002237) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Shandong Humon Smelting's Net Debt?

As you can see below, Shandong Humon Smelting had CN¥11.1b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of CN¥4.25b, its net debt is less, at about CN¥6.85b.

A Look At Shandong Humon Smelting's Liabilities

The latest balance sheet data shows that Shandong Humon Smelting had liabilities of CN¥8.76b due within a year, and liabilities of CN¥5.70b falling due after that. Offsetting this, it had CN¥4.25b in cash and CN¥1.24b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.97b.

This is a mountain of leverage relative to its market capitalization of CN¥10.5b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Shandong Humon Smelting's debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 4.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Also relevant is that Shandong Humon Smelting has grown its EBIT by a very respectable 20% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Shandong Humon Smelting'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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shandong Humon Smelting reported free cash flow worth 14% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Shandong Humon Smelting's net debt to EBITDA and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think Shandong Humon Smelting's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 3 warning signs for Shandong Humon Smelting (1 is a bit unpleasant) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.