The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Hubei Xingfa Chemicals Group Co., Ltd. (SHSE:600141) does use debt in its business. But is this debt a concern to shareholders?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for Hubei Xingfa Chemicals Group
What Is Hubei Xingfa Chemicals Group's Net Debt?
As you can see below, at the end of June 2023, Hubei Xingfa Chemicals Group had CN¥12.6b of debt, up from CN¥10.9b a year ago. Click the image for more detail. However, it does have CN¥3.72b in cash offsetting this, leading to net debt of about CN¥8.92b.
How Strong Is Hubei Xingfa Chemicals Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Hubei Xingfa Chemicals Group had liabilities of CN¥10.8b due within 12 months and liabilities of CN¥10.5b due beyond that. Offsetting these obligations, it had cash of CN¥3.72b as well as receivables valued at CN¥2.32b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥15.3b.
This is a mountain of leverage relative to its market capitalization of CN¥19.2b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
Hubei Xingfa Chemicals Group's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its commanding EBIT of 24.1 times its interest expense, implies the debt load is as light as a peacock feather. It is just as well that Hubei Xingfa Chemicals Group's load is not too heavy, because its EBIT was down 63% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hubei Xingfa Chemicals Group 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Hubei Xingfa Chemicals Group recorded free cash flow worth 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Our View
Neither Hubei Xingfa Chemicals Group's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Hubei Xingfa Chemicals Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 4 warning signs for Hubei Xingfa Chemicals Group you should be aware of, and 1 of them makes us a bit uncomfortable.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.