Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Jiangsu HHCK Advanced Materials Co.,Ltd (SHSE:688535) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

What Is Jiangsu HHCK Advanced MaterialsLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Jiangsu HHCK Advanced MaterialsLtd had debt of CN¥60.4m, up from CN¥46.9m in one year. However, it does have CN¥26.6m in cash offsetting this, leading to net debt of about CN¥33.7m.

A Look At Jiangsu HHCK Advanced MaterialsLtd's Liabilities

We can see from the most recent balance sheet that Jiangsu HHCK Advanced MaterialsLtd had liabilities of CN¥190.8m falling due within a year, and liabilities of CN¥30.3m due beyond that. On the other hand, it had cash of CN¥26.6m and CN¥203.2m worth of receivables due within a year. So it actually has CN¥8.72m more liquid assets than total liabilities.

Having regard to Jiangsu HHCK Advanced MaterialsLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥7.49b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Jiangsu HHCK Advanced MaterialsLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Jiangsu HHCK Advanced MaterialsLtd has net debt of just 0.98 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. But the bad news is that Jiangsu HHCK Advanced MaterialsLtd has seen its EBIT plunge 12% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Jiangsu HHCK Advanced MaterialsLtd 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Jiangsu HHCK Advanced MaterialsLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Jiangsu HHCK Advanced MaterialsLtd's conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Jiangsu HHCK Advanced MaterialsLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Jiangsu HHCK Advanced MaterialsLtd is showing 1 warning sign in our investment analysis , you should know about...

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.

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.