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. As with many other companies Haohua Chemical Science & Technology Corp., Ltd. (SHSE:600378) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Haohua Chemical Science & Technology's Debt?

As you can see below, at the end of March 2024, Haohua Chemical Science & Technology had CN¥2.77b of debt, up from CN¥2.08b a year ago. Click the image for more detail. However, it does have CN¥2.13b in cash offsetting this, leading to net debt of about CN¥641.8m.

How Strong Is Haohua Chemical Science & Technology's Balance Sheet?

The latest balance sheet data shows that Haohua Chemical Science & Technology had liabilities of CN¥3.92b due within a year, and liabilities of CN¥3.04b falling due after that. Offsetting this, it had CN¥2.13b in cash and CN¥3.59b in receivables that were due within 12 months. So it has liabilities totalling CN¥1.24b more than its cash and near-term receivables, combined.

Given Haohua Chemical Science & Technology has a market capitalization of CN¥27.3b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Haohua Chemical Science & Technology has a low debt to EBITDA ratio of only 0.51. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. In fact Haohua Chemical Science & Technology's saving grace is its low debt levels, because its EBIT has tanked 23% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Haohua Chemical Science & Technology's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. During the last three years, Haohua Chemical Science & Technology burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Haohua Chemical Science & Technology's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Haohua Chemical Science & Technology's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For instance, we've identified 1 warning sign for Haohua Chemical Science & Technology that 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.