Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Shandong Huatai Paper Industry Shareholding Co.,Ltd (SHSE:600308) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Shandong Huatai Paper Industry ShareholdingLtd's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2023 Shandong Huatai Paper Industry ShareholdingLtd had CN¥2.62b of debt, an increase on CN¥2.28b, over one year. However, because it has a cash reserve of CN¥2.25b, its net debt is less, at about CN¥370.0m.
A Look At Shandong Huatai Paper Industry ShareholdingLtd's Liabilities
The latest balance sheet data shows that Shandong Huatai Paper Industry ShareholdingLtd had liabilities of CN¥5.74b due within a year, and liabilities of CN¥412.1m falling due after that. Offsetting these obligations, it had cash of CN¥2.25b as well as receivables valued at CN¥2.65b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.25b.
Shandong Huatai Paper Industry ShareholdingLtd has a market capitalization of CN¥4.31b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Shandong Huatai Paper Industry ShareholdingLtd has net debt of just 0.36 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.2 times the interest expense over the last year. It is just as well that Shandong Huatai Paper Industry ShareholdingLtd's load is not too heavy, because its EBIT was down 72% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shandong Huatai Paper Industry ShareholdingLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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 most recent three years, Shandong Huatai Paper Industry ShareholdingLtd recorded free cash flow worth 67% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
Shandong Huatai Paper Industry ShareholdingLtd's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its net debt to EBITDA. When we consider all the factors mentioned above, we do feel a bit cautious about Shandong Huatai Paper Industry ShareholdingLtd'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. 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. For example, we've discovered 2 warning signs for Shandong Huatai Paper Industry ShareholdingLtd (1 is a bit unpleasant!) that you should be aware of before investing here.
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.