Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Wuzhou Special Paper Group Co., Ltd. (SHSE:605007) makes use of debt. But is this debt a concern to shareholders?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Wuzhou Special Paper Group Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Wuzhou Special Paper Group had debt of CN¥5.11b, up from CN¥3.29b in one year. However, it also had CN¥499.6m in cash, and so its net debt is CN¥4.61b.

How Healthy Is Wuzhou Special Paper Group's Balance Sheet?

We can see from the most recent balance sheet that Wuzhou Special Paper Group had liabilities of CN¥4.21b falling due within a year, and liabilities of CN¥2.74b due beyond that. Offsetting these obligations, it had cash of CN¥499.6m as well as receivables valued at CN¥1.32b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.13b.

This deficit is considerable relative to its market capitalization of CN¥5.55b, so it does suggest shareholders should keep an eye on Wuzhou Special Paper 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.

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).

Strangely Wuzhou Special Paper Group has a sky high EBITDA ratio of 5.2, implying high debt, but a strong interest coverage of 28.5. So either it has access to very cheap long term debt or that interest expense is going to grow! Notably, Wuzhou Special Paper Group's EBIT launched higher than Elon Musk, gaining a whopping 311% on last year. 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 Wuzhou Special Paper 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Wuzhou Special Paper Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While Wuzhou Special Paper Group's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Wuzhou Special Paper Group'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. 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. For example Wuzhou Special Paper Group has 3 warning signs (and 2 which are significant) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.