Warren Buffett famously said, '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. As with many other companies Guizhou Zhenhua E-chem Inc. (SHSE:688707) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 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 Guizhou Zhenhua E-chem's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Guizhou Zhenhua E-chem had CN¥2.13b of debt in September 2023, down from CN¥2.22b, one year before. However, because it has a cash reserve of CN¥1.42b, its net debt is less, at about CN¥714.4m.

How Healthy Is Guizhou Zhenhua E-chem's Balance Sheet?

The latest balance sheet data shows that Guizhou Zhenhua E-chem had liabilities of CN¥3.73b due within a year, and liabilities of CN¥1.21b falling due after that. Offsetting these obligations, it had cash of CN¥1.42b as well as receivables valued at CN¥2.45b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.06b.

Given Guizhou Zhenhua E-chem has a market capitalization of CN¥6.98b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Guizhou Zhenhua E-chem's debt to EBITDA ratio (2.9) suggests that it uses some debt, its interest cover is very weak, at 1.4, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, Guizhou Zhenhua E-chem saw its EBIT tank 92% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Guizhou Zhenhua E-chem'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Guizhou Zhenhua E-chem's free cash flow amounted to 36% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Guizhou Zhenhua E-chem's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to handle its total liabilities isn't such a worry. Once we consider all the factors above, together, it seems to us that Guizhou Zhenhua E-chem's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Guizhou Zhenhua E-chem , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.