Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Jilin Chemical Fibre Stock Co.,Ltd (SZSE:000420) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, 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.

How Much Debt Does Jilin Chemical Fibre StockLtd Carry?

The image below, which you can click on for greater detail, shows that Jilin Chemical Fibre StockLtd had debt of CN¥3.17b at the end of March 2024, a reduction from CN¥3.39b over a year. On the flip side, it has CN¥744.2m in cash leading to net debt of about CN¥2.42b.

A Look At Jilin Chemical Fibre StockLtd's Liabilities

According to the last reported balance sheet, Jilin Chemical Fibre StockLtd had liabilities of CN¥5.19b due within 12 months, and liabilities of CN¥1.30b due beyond 12 months. Offsetting these obligations, it had cash of CN¥744.2m as well as receivables valued at CN¥973.0m due within 12 months. So it has liabilities totalling CN¥4.77b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Jilin Chemical Fibre StockLtd is worth CN¥8.97b, and thus could probably raise enough capital to shore up 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Jilin Chemical Fibre StockLtd has a debt to EBITDA ratio of 2.6, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 21.5 is very high, suggesting that the interest expense on the debt is currently quite low. Notably, Jilin Chemical Fibre StockLtd's EBIT launched higher than Elon Musk, gaining a whopping 101% on last year. 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 Jilin Chemical Fibre StockLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Jilin Chemical Fibre StockLtd 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

Jilin Chemical Fibre StockLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Jilin Chemical Fibre StockLtd's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Be aware that Jilin Chemical Fibre StockLtd is showing 2 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.