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.' 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. We can see that Shan Dong Lu Bei Chemical Co.,Ltd (SHSE:600727) does use debt in its business. But the real question is whether this debt is making the company risky.

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. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Shan Dong Lu Bei ChemicalLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Shan Dong Lu Bei ChemicalLtd had debt of CN¥2.60b, up from CN¥661.3m in one year. However, because it has a cash reserve of CN¥2.36b, its net debt is less, at about CN¥245.7m.

How Healthy Is Shan Dong Lu Bei ChemicalLtd's Balance Sheet?

According to the last reported balance sheet, Shan Dong Lu Bei ChemicalLtd had liabilities of CN¥5.12b due within 12 months, and liabilities of CN¥167.3m due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.36b as well as receivables valued at CN¥1.15b due within 12 months. So it has liabilities totalling CN¥1.78b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Shan Dong Lu Bei ChemicalLtd has a market capitalization of CN¥4.06b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Shan Dong Lu Bei ChemicalLtd has a low debt to EBITDA ratio of only 0.48. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. It was also good to see that despite losing money on the EBIT line last year, Shan Dong Lu Bei ChemicalLtd turned things around in the last 12 months, delivering and EBIT of CN¥245m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shan Dong Lu Bei ChemicalLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Shan Dong Lu Bei ChemicalLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We feel some trepidation about Shan Dong Lu Bei ChemicalLtd's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Shan Dong Lu Bei ChemicalLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example Shan Dong Lu Bei ChemicalLtd has 3 warning signs (and 1 which is a bit concerning) we think you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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