David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Shandong Hualu-Hengsheng Chemical Co., Ltd. (SHSE:600426) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Shandong Hualu-Hengsheng Chemical

What Is Shandong Hualu-Hengsheng Chemical's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Shandong Hualu-Hengsheng Chemical had CN¥7.51b of debt, an increase on CN¥3.72b, over one year. However, it does have CN¥2.24b in cash offsetting this, leading to net debt of about CN¥5.27b.

How Strong Is Shandong Hualu-Hengsheng Chemical's Balance Sheet?

According to the last reported balance sheet, Shandong Hualu-Hengsheng Chemical had liabilities of CN¥4.49b due within 12 months, and liabilities of CN¥7.17b due beyond 12 months. Offsetting this, it had CN¥2.24b in cash and CN¥2.24b in receivables that were due within 12 months. So its liabilities total CN¥7.18b more than the combination of its cash and short-term receivables.

Since publicly traded Shandong Hualu-Hengsheng Chemical shares are worth a total of CN¥65.1b, it seems unlikely that this level of liabilities would be a major 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shandong Hualu-Hengsheng Chemical has a low net debt to EBITDA ratio of only 0.80. And its EBIT easily covers its interest expense, being 205 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 Hualu-Hengsheng Chemical's saving grace is its low debt levels, because its EBIT has tanked 46% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shandong Hualu-Hengsheng Chemical's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shandong Hualu-Hengsheng Chemical recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Shandong Hualu-Hengsheng Chemical's EBIT growth rate and conversion of EBIT to free cash flow 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. Taking the abovementioned factors together we do think Shandong Hualu-Hengsheng Chemical's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Shandong Hualu-Hengsheng Chemical is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.