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 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. Importantly, Satellite Chemical Co.,Ltd. (SZSE:002648) does carry debt. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Satellite ChemicalLtd Carry?
The image below, which you can click on for greater detail, shows that at June 2024 Satellite ChemicalLtd had debt of CN¥12.6b, up from CN¥11.4b in one year. However, it does have CN¥4.72b in cash offsetting this, leading to net debt of about CN¥7.92b.
A Look At Satellite ChemicalLtd's Liabilities
The latest balance sheet data shows that Satellite ChemicalLtd had liabilities of CN¥14.3b due within a year, and liabilities of CN¥25.1b falling due after that. Offsetting these obligations, it had cash of CN¥4.72b as well as receivables valued at CN¥2.27b due within 12 months. So its liabilities total CN¥32.3b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of CN¥50.2b, so it does suggest shareholders should keep an eye on Satellite ChemicalLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
Satellite ChemicalLtd's net debt is only 0.87 times its EBITDA. And its EBIT easily covers its interest expense, being 24.9 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Satellite ChemicalLtd grew its EBIT by 111% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Satellite ChemicalLtd 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 always check how much of that EBIT is translated into free cash flow. During the last three years, Satellite ChemicalLtd produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
The good news is that Satellite ChemicalLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. When we consider the range of factors above, it looks like Satellite ChemicalLtd is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. We've identified 1 warning sign with Satellite ChemicalLtd , and understanding them should be part of your investment process.
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.
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.