Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Kunming Chuan Jin Nuo Chemical Co., Ltd. (SZSE:300505) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Kunming Chuan Jin Nuo Chemical

How Much Debt Does Kunming Chuan Jin Nuo Chemical Carry?

The image below, which you can click on for greater detail, shows that Kunming Chuan Jin Nuo Chemical had debt of CN¥527.8m at the end of March 2022, a reduction from CN¥578.0m over a year. However, because it has a cash reserve of CN¥291.7m, its net debt is less, at about CN¥236.2m.

How Strong Is Kunming Chuan Jin Nuo Chemical's Balance Sheet?

According to the last reported balance sheet, Kunming Chuan Jin Nuo Chemical had liabilities of CN¥518.7m due within 12 months, and liabilities of CN¥338.4m due beyond 12 months. On the other hand, it had cash of CN¥291.7m and CN¥89.2m worth of receivables due within a year. So it has liabilities totalling CN¥476.4m more than its cash and near-term receivables, combined.

Given Kunming Chuan Jin Nuo Chemical has a market capitalization of CN¥6.53b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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).

Kunming Chuan Jin Nuo Chemical's net debt is only 0.59 times its EBITDA. And its EBIT covers its interest expense a whopping 23.5 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Kunming Chuan Jin Nuo Chemical grew its EBIT by 705% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is Kunming Chuan Jin Nuo Chemical'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Kunming Chuan Jin Nuo Chemical saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Happily, Kunming Chuan Jin Nuo Chemical's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Kunming Chuan Jin Nuo Chemical can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Kunming Chuan Jin Nuo Chemical (1 is significant!) that you should be aware of before investing here.

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.