David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Jiangsu Huahong Technology Co., Ltd. (SZSE:002645) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Jiangsu Huahong Technology

How Much Debt Does Jiangsu Huahong Technology Carry?

The image below, which you can click on for greater detail, shows that at March 2022 Jiangsu Huahong Technology had debt of CN¥272.6m, up from CN¥166.7m in one year. However, its balance sheet shows it holds CN¥458.1m in cash, so it actually has CN¥185.5m net cash.

How Strong Is Jiangsu Huahong Technology's Balance Sheet?

We can see from the most recent balance sheet that Jiangsu Huahong Technology had liabilities of CN¥1.48b falling due within a year, and liabilities of CN¥31.3m due beyond that. Offsetting these obligations, it had cash of CN¥458.1m as well as receivables valued at CN¥653.8m due within 12 months. So it has liabilities totalling CN¥403.1m more than its cash and near-term receivables, combined.

Since publicly traded Jiangsu Huahong Technology shares are worth a total of CN¥12.3b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Jiangsu Huahong Technology also has more cash than debt, so we're pretty confident it can manage its debt safely.

On top of that, Jiangsu Huahong Technology grew its EBIT by 96% over the last twelve months, and that growth will make it easier to handle its 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 Jiangsu Huahong Technology can strengthen its balance sheet over time. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Jiangsu Huahong Technology may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Jiangsu Huahong Technology reported free cash flow worth 14% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Jiangsu Huahong Technology has CN¥185.5m in net cash. And it impressed us with its EBIT growth of 96% over the last year. So is Jiangsu Huahong Technology's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Jiangsu Huahong Technology (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

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.