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.' 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 Milkyway Chemical Supply Chain Service Co.,Ltd (SHSE:603713) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Milkyway Chemical Supply Chain ServiceLtd's Net Debt?

As you can see below, at the end of September 2023, Milkyway Chemical Supply Chain ServiceLtd had CN¥4.05b of debt, up from CN¥2.27b a year ago. Click the image for more detail. On the flip side, it has CN¥1.52b in cash leading to net debt of about CN¥2.53b.

A Look At Milkyway Chemical Supply Chain ServiceLtd's Liabilities

We can see from the most recent balance sheet that Milkyway Chemical Supply Chain ServiceLtd had liabilities of CN¥5.37b falling due within a year, and liabilities of CN¥1.94b due beyond that. Offsetting these obligations, it had cash of CN¥1.52b as well as receivables valued at CN¥3.32b due within 12 months. So its liabilities total CN¥2.47b more than the combination of its cash and short-term receivables.

Milkyway Chemical Supply Chain ServiceLtd has a market capitalization of CN¥8.02b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Milkyway Chemical Supply Chain ServiceLtd has net debt to EBITDA of 2.7 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 7.8 times its interest expense, and its net debt to EBITDA, was quite high, at 2.7. Unfortunately, Milkyway Chemical Supply Chain ServiceLtd saw its EBIT slide 6.8% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Milkyway Chemical Supply Chain ServiceLtd'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Milkyway Chemical Supply Chain ServiceLtd 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

Mulling over Milkyway Chemical Supply Chain ServiceLtd's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Milkyway Chemical Supply Chain ServiceLtd stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 Milkyway Chemical Supply Chain ServiceLtd has 2 warning signs (and 1 which is significant) we think you should know about.

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.