Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 China National Chemical Engineering Co., Ltd (SHSE:601117) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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.
What Is China National Chemical Engineering's Net Debt?
As you can see below, at the end of September 2023, China National Chemical Engineering had CN¥12.2b of debt, up from CN¥8.32b a year ago. Click the image for more detail. However, it does have CN¥36.8b in cash offsetting this, leading to net cash of CN¥24.7b.
How Healthy Is China National Chemical Engineering's Balance Sheet?
According to the last reported balance sheet, China National Chemical Engineering had liabilities of CN¥137.2b due within 12 months, and liabilities of CN¥13.1b due beyond 12 months. Offsetting this, it had CN¥36.8b in cash and CN¥94.6b in receivables that were due within 12 months. So its liabilities total CN¥18.9b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since China National Chemical Engineering has a market capitalization of CN¥41.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, China National Chemical Engineering boasts net cash, so it's fair to say it does not have a heavy debt load!
Also good is that China National Chemical Engineering grew its EBIT at 19% over the last year, further increasing its ability to manage debt. 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 China National Chemical Engineering 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While China National Chemical Engineering has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, China National Chemical Engineering recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Summing Up
While China National Chemical Engineering does have more liabilities than liquid assets, it also has net cash of CN¥24.7b. And we liked the look of last year's 19% year-on-year EBIT growth. So we don't have any problem with China National Chemical Engineering's use of debt. 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 1 warning sign for China National Chemical Engineering you should be aware of.
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.