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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Wanhua Chemical Group Co., Ltd. (SHSE:600309) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Wanhua Chemical Group Carry?

As you can see below, Wanhua Chemical Group had CN¥121.1b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of CN¥41.2b, its net debt is less, at about CN¥79.9b.

How Strong Is Wanhua Chemical Group's Balance Sheet?

The latest balance sheet data shows that Wanhua Chemical Group had liabilities of CN¥139.4b due within a year, and liabilities of CN¥68.7b falling due after that. Offsetting this, it had CN¥41.2b in cash and CN¥18.1b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥148.7b.

This deficit is considerable relative to its very significant market capitalization of CN¥245.1b, so it does suggest shareholders should keep an eye on Wanhua Chemical 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 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.

Wanhua Chemical Group's net debt is 2.5 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 16.4 is very high, suggesting that the interest expense on the debt is currently quite low. Wanhua Chemical Group grew its EBIT by 2.4% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Wanhua Chemical Group's ability to maintain a healthy balance sheet going forward. 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. During the last three years, Wanhua Chemical 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

Neither Wanhua Chemical Group's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Wanhua Chemical Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Wanhua Chemical Group you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.