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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Shandong Dawn Polymer Co.,Ltd. (SZSE:002838) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Shandong Dawn PolymerLtd

What Is Shandong Dawn PolymerLtd's Debt?

The image below, which you can click on for greater detail, shows that at December 2021 Shandong Dawn PolymerLtd had debt of CN¥448.6m, up from CN¥317.0m in one year. However, it also had CN¥359.7m in cash, and so its net debt is CN¥89.0m.

How Healthy Is Shandong Dawn PolymerLtd's Balance Sheet?

According to the last reported balance sheet, Shandong Dawn PolymerLtd had liabilities of CN¥570.4m due within 12 months, and liabilities of CN¥392.0m due beyond 12 months. Offsetting this, it had CN¥359.7m in cash and CN¥1.02b in receivables that were due within 12 months. So it can boast CN¥419.0m more liquid assets than total liabilities.

This short term liquidity is a sign that Shandong Dawn PolymerLtd could probably pay off its debt with ease, as its balance sheet is far from stretched. But either way, Shandong Dawn PolymerLtd 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shandong Dawn PolymerLtd's net debt is only 0.27 times its EBITDA. And its EBIT easily covers its interest expense, being 28.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Shandong Dawn PolymerLtd's saving grace is its low debt levels, because its EBIT has tanked 72% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is Shandong Dawn PolymerLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Looking at the most recent three years, Shandong Dawn PolymerLtd recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Based on what we've seen Shandong Dawn PolymerLtd is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Shandong Dawn PolymerLtd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Case in point: We've spotted 2 warning signs for Shandong Dawn PolymerLtd you should be aware of, and 1 of them is a bit unpleasant.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.