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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Hubei Xingfa Chemicals Group Co., Ltd. (SHSE:600141) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Hubei Xingfa Chemicals Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Hubei Xingfa Chemicals Group had CN¥12.2b of debt, an increase on CN¥11.5b, over one year. However, it does have CN¥2.32b in cash offsetting this, leading to net debt of about CN¥9.83b.

How Strong Is Hubei Xingfa Chemicals Group's Balance Sheet?

The latest balance sheet data shows that Hubei Xingfa Chemicals Group had liabilities of CN¥11.8b due within a year, and liabilities of CN¥10.8b falling due after that. Offsetting this, it had CN¥2.32b in cash and CN¥2.47b in receivables that were due within 12 months. So its liabilities total CN¥17.8b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥22.8b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

We'd say that Hubei Xingfa Chemicals Group's moderate net debt to EBITDA ratio ( being 2.4), indicates prudence when it comes to debt. And its strong interest cover of 10.0 times, makes us even more comfortable. Importantly, Hubei Xingfa Chemicals Group's EBIT fell a jaw-dropping 75% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Hubei Xingfa Chemicals Group 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.

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. Looking at the most recent three years, Hubei Xingfa Chemicals Group recorded free cash flow of 44% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Hubei Xingfa Chemicals Group's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Hubei Xingfa Chemicals Group stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less 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. For example Hubei Xingfa Chemicals Group has 3 warning signs (and 1 which is potentially serious) we think you should know about.

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.