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 Tangshan Sanyou Chemical Industries Co.,Ltd (SHSE:600409) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Tangshan Sanyou Chemical IndustriesLtd Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Tangshan Sanyou Chemical IndustriesLtd had debt of CN¥4.71b, up from CN¥3.95b in one year. However, it also had CN¥2.68b in cash, and so its net debt is CN¥2.04b.

How Healthy Is Tangshan Sanyou Chemical IndustriesLtd's Balance Sheet?

The latest balance sheet data shows that Tangshan Sanyou Chemical IndustriesLtd had liabilities of CN¥5.34b due within a year, and liabilities of CN¥5.14b falling due after that. On the other hand, it had cash of CN¥2.68b and CN¥3.12b worth of receivables due within a year. So it has liabilities totalling CN¥4.67b more than its cash and near-term receivables, combined.

Tangshan Sanyou Chemical IndustriesLtd has a market capitalization of CN¥11.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Tangshan Sanyou Chemical IndustriesLtd has a low net debt to EBITDA ratio of only 0.69. And its EBIT covers its interest expense a whopping 11.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Tangshan Sanyou Chemical IndustriesLtd has increased its EBIT by 9.2% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Tangshan Sanyou Chemical IndustriesLtd 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Tangshan Sanyou Chemical IndustriesLtd produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Tangshan Sanyou Chemical IndustriesLtd's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its interest cover is also very heartening. When we consider the range of factors above, it looks like Tangshan Sanyou Chemical IndustriesLtd is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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 example, we've discovered 1 warning sign for Tangshan Sanyou Chemical IndustriesLtd that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.

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