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.' 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 Orinko Advanced Plastics Co.,LTD (SHSE:688219) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. 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.

What Is Orinko Advanced PlasticsLTD's Net Debt?

As you can see below, Orinko Advanced PlasticsLTD had CN¥2.32b 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¥1.03b, its net debt is less, at about CN¥1.30b.

How Strong Is Orinko Advanced PlasticsLTD's Balance Sheet?

The latest balance sheet data shows that Orinko Advanced PlasticsLTD had liabilities of CN¥3.34b due within a year, and liabilities of CN¥1.48b falling due after that. Offsetting these obligations, it had cash of CN¥1.03b as well as receivables valued at CN¥2.37b due within 12 months. So it has liabilities totalling CN¥1.43b more than its cash and near-term receivables, combined.

Orinko Advanced PlasticsLTD has a market capitalization of CN¥4.37b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

Orinko Advanced PlasticsLTD's debt is 3.4 times its EBITDA, and its EBIT cover its interest expense 4.1 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Looking on the bright side, Orinko Advanced PlasticsLTD boosted its EBIT by a silky 51% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Orinko Advanced PlasticsLTD will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Orinko Advanced PlasticsLTD 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

Neither Orinko Advanced PlasticsLTD's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. We think that Orinko Advanced PlasticsLTD'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. 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. For example Orinko Advanced PlasticsLTD has 2 warning signs (and 1 which doesn't sit too well with us) 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.