Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Shandong Sinocera Functional Material Co., Ltd. (SZSE:300285) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Shandong Sinocera Functional Material's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Shandong Sinocera Functional Material had debt of CN¥605.1m, up from CN¥399.3m in one year. However, it also had CN¥543.5m in cash, and so its net debt is CN¥61.6m.

A Look At Shandong Sinocera Functional Material's Liabilities

Zooming in on the latest balance sheet data, we can see that Shandong Sinocera Functional Material had liabilities of CN¥1.40b due within 12 months and liabilities of CN¥554.3m due beyond that. On the other hand, it had cash of CN¥543.5m and CN¥2.32b worth of receivables due within a year. So it actually has CN¥905.2m more liquid assets than total liabilities.

This surplus suggests that Shandong Sinocera Functional Material has a conservative balance sheet, and could probably eliminate its debt without much difficulty. But either way, Shandong Sinocera Functional Material has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Shandong Sinocera Functional Material has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.064 and EBIT of 98.9 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. In addition to that, we're happy to report that Shandong Sinocera Functional Material has boosted its EBIT by 48%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shandong Sinocera Functional Material 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Shandong Sinocera Functional Material actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Shandong Sinocera Functional Material's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Zooming out, Shandong Sinocera Functional Material seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. Over time, share prices tend to follow earnings per share, so if you're interested in Shandong Sinocera Functional Material, you may well want to click here to check an interactive graph of its earnings per share history.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.