Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Hangzhou Oxygen Plant Group Co.,Ltd. (SZSE:002430) makes use of debt. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. 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 Hangzhou Oxygen Plant GroupLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Hangzhou Oxygen Plant GroupLtd had CN¥6.28b of debt, an increase on CN¥4.65b, over one year. However, it also had CN¥3.25b in cash, and so its net debt is CN¥3.03b.

How Strong Is Hangzhou Oxygen Plant GroupLtd's Balance Sheet?

The latest balance sheet data shows that Hangzhou Oxygen Plant GroupLtd had liabilities of CN¥8.78b due within a year, and liabilities of CN¥3.89b falling due after that. Offsetting these obligations, it had cash of CN¥3.25b as well as receivables valued at CN¥4.23b due within 12 months. So its liabilities total CN¥5.19b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Hangzhou Oxygen Plant GroupLtd is worth CN¥18.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Hangzhou Oxygen Plant GroupLtd's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 21.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Hangzhou Oxygen Plant GroupLtd saw its EBIT decline by 6.1% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hangzhou Oxygen Plant GroupLtd 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Hangzhou Oxygen Plant GroupLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Hangzhou Oxygen Plant GroupLtd's ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Hangzhou Oxygen Plant GroupLtd'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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Hangzhou Oxygen Plant GroupLtd , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

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