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.' 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. As with many other companies Shanxi Blue Flame Holding Company Limited (SZSE:000968) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

How Much Debt Does Shanxi Blue Flame Holding Carry?

The image below, which you can click on for greater detail, shows that Shanxi Blue Flame Holding had debt of CN¥3.65b at the end of March 2024, a reduction from CN¥4.36b over a year. On the flip side, it has CN¥1.56b in cash leading to net debt of about CN¥2.10b.

How Healthy Is Shanxi Blue Flame Holding's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanxi Blue Flame Holding had liabilities of CN¥2.35b due within 12 months and liabilities of CN¥3.09b due beyond that. On the other hand, it had cash of CN¥1.56b and CN¥1.58b worth of receivables due within a year. So it has liabilities totalling CN¥2.30b more than its cash and near-term receivables, combined.

Shanxi Blue Flame Holding has a market capitalization of CN¥6.41b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a debt to EBITDA ratio of 1.7, Shanxi Blue Flame Holding uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.3 times interest expense) certainly does not do anything to dispel this impression. Sadly, Shanxi Blue Flame Holding's EBIT actually dropped 3.9% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shanxi Blue Flame Holding 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.

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, Shanxi Blue Flame Holding reported free cash flow worth 20% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

While Shanxi Blue Flame Holding's EBIT growth rate makes us cautious about it, its track record of converting EBIT to free cash flow is no better. At least its interest cover gives us reason to be optimistic. We think that Shanxi Blue Flame Holding's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Shanxi Blue Flame Holding , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.