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.' 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. We note that Shandong Chenming Paper Holdings Limited (SZSE:000488) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View 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¥41.5b at the end of June 2023, a reduction from CN¥44.5b over a year. However, because it has a cash reserve of CN¥13.7b, its net debt is less, at about CN¥27.8b.

How Strong Is Shandong Chenming Paper Holdings' Balance Sheet?

The latest balance sheet data shows that Shandong Chenming Paper Holdings had liabilities of CN¥50.6b due within a year, and liabilities of CN¥9.19b falling due after that. Offsetting these obligations, it had cash of CN¥13.7b as well as receivables valued at CN¥9.55b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥36.5b.

This deficit casts a shadow over the CN¥9.85b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shandong Chenming Paper Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (9.7), and fairly weak interest coverage, since EBIT is just 0.32 times the interest expense. The debt burden here is substantial. Worse, Shandong Chenming Paper Holdings's EBIT was down 79% 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 ultimately the future profitability of the business will decide if Shandong Chenming Paper Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shandong Chenming Paper Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

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 at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Taking into account all the aforementioned factors, it looks like Shandong Chenming Paper Holdings has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Shandong Chenming Paper Holdings 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.