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 Jiangxi Hungpai New Material Co., Ltd. (SHSE:605366) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Jiangxi Hungpai New Material's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Jiangxi Hungpai New Material had debt of CN¥813.1m, up from CN¥633.1m in one year. However, it also had CN¥340.0m in cash, and so its net debt is CN¥473.1m.

How Strong Is Jiangxi Hungpai New Material's Balance Sheet?

We can see from the most recent balance sheet that Jiangxi Hungpai New Material had liabilities of CN¥439.7m falling due within a year, and liabilities of CN¥699.9m due beyond that. On the other hand, it had cash of CN¥340.0m and CN¥522.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥277.5m.

Of course, Jiangxi Hungpai New Material has a market capitalization of CN¥3.96b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Jiangxi Hungpai New Material's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 4.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even worse, Jiangxi Hungpai New Material saw its EBIT tank 82% 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. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Jiangxi Hungpai New Material 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Jiangxi Hungpai New Material burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Jiangxi Hungpai New Material's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Jiangxi Hungpai New Material's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Jiangxi Hungpai New Material you should be aware of, and 2 of them are significant.

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.