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.' 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. We can see that Hunan Junxin Environmental Protection Co., Ltd. (SZSE:301109) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Hunan Junxin Environmental Protection's Debt?

The chart below, which you can click on for greater detail, shows that Hunan Junxin Environmental Protection had CN¥2.65b in debt in June 2024; about the same as the year before. However, because it has a cash reserve of CN¥1.74b, its net debt is less, at about CN¥905.2m.

How Strong Is Hunan Junxin Environmental Protection's Balance Sheet?

According to the last reported balance sheet, Hunan Junxin Environmental Protection had liabilities of CN¥942.6m due within 12 months, and liabilities of CN¥3.04b due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.74b as well as receivables valued at CN¥865.0m due within 12 months. So it has liabilities totalling CN¥1.38b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Hunan Junxin Environmental Protection has a market capitalization of CN¥6.21b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hunan Junxin Environmental Protection's net debt is only 0.83 times its EBITDA. And its EBIT covers its interest expense a whopping 10.2 times over. So we're pretty relaxed about its super-conservative use of debt. The good news is that Hunan Junxin Environmental Protection has increased its EBIT by 6.3% 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 you can't view debt in total isolation; since Hunan Junxin Environmental Protection will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. In the last three years, Hunan Junxin Environmental Protection's free cash flow amounted to 49% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, Hunan Junxin Environmental Protection's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! All these things considered, it appears that Hunan Junxin Environmental Protection can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Hunan Junxin Environmental Protection .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.