Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Milkyway Chemical Supply Chain Service Co., Ltd. (SHSE:603713) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Milkyway Chemical Supply Chain Service

What Is Milkyway Chemical Supply Chain Service's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Milkyway Chemical Supply Chain Service had CN¥1.59b of debt, an increase on CN¥600.7m, over one year. However, because it has a cash reserve of CN¥1.41b, its net debt is less, at about CN¥184.7m.

How Healthy Is Milkyway Chemical Supply Chain Service's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Milkyway Chemical Supply Chain Service had liabilities of CN¥3.80b due within 12 months and liabilities of CN¥907.8m due beyond that. Offsetting these obligations, it had cash of CN¥1.41b as well as receivables valued at CN¥3.31b due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

This state of affairs indicates that Milkyway Chemical Supply Chain Service's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥21.9b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Milkyway Chemical Supply Chain Service has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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

Milkyway Chemical Supply Chain Service has a low net debt to EBITDA ratio of only 0.21. And its EBIT covers its interest expense a whopping 15.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Milkyway Chemical Supply Chain Service grew its EBIT by 74% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Milkyway Chemical Supply Chain Service 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Milkyway Chemical Supply Chain Service reported free cash flow worth 8.8% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Milkyway Chemical Supply Chain Service's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Zooming out, Milkyway Chemical Supply Chain Service seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Milkyway Chemical Supply Chain Service you should be aware of.

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.