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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Hubei Xingfa Chemicals Group Co., Ltd. (SHSE:600141) 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. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Hubei Xingfa Chemicals Group Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Hubei Xingfa Chemicals Group had debt of CN¥13.5b, up from CN¥12.6b in one year. However, it also had CN¥2.07b in cash, and so its net debt is CN¥11.4b.

How Healthy Is Hubei Xingfa Chemicals Group's Balance Sheet?

According to the last reported balance sheet, Hubei Xingfa Chemicals Group had liabilities of CN¥11.9b due within 12 months, and liabilities of CN¥11.4b due beyond 12 months. On the other hand, it had cash of CN¥2.07b and CN¥2.83b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥18.4b.

This deficit is considerable relative to its market capitalization of CN¥20.5b, so it does suggest shareholders should keep an eye on Hubei Xingfa Chemicals Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

With net debt to EBITDA of 2.6 Hubei Xingfa Chemicals Group has a fairly noticeable amount of debt. On the plus side, its EBIT was 9.0 times its interest expense, and its net debt to EBITDA, was quite high, at 2.6. Importantly, Hubei Xingfa Chemicals Group's EBIT fell a jaw-dropping 39% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hubei Xingfa Chemicals Group 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.

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. Looking at the most recent three years, Hubei Xingfa Chemicals Group recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Hubei Xingfa Chemicals Group's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Hubei Xingfa Chemicals Group's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Hubei Xingfa Chemicals Group you should be aware of, and 1 of them is a bit unpleasant.

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.