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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Hainan Haiyao Co., Ltd. (SZSE:000566) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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.

View our latest analysis for Hainan Haiyao

What Is Hainan Haiyao's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Hainan Haiyao had CN¥3.33b of debt in March 2022, down from CN¥3.56b, one year before. However, it also had CN¥1.31b in cash, and so its net debt is CN¥2.03b.

How Strong Is Hainan Haiyao's Balance Sheet?

According to the last reported balance sheet, Hainan Haiyao had liabilities of CN¥4.29b due within 12 months, and liabilities of CN¥1.48b due beyond 12 months. On the other hand, it had cash of CN¥1.31b and CN¥1.55b worth of receivables due within a year. So it has liabilities totalling CN¥2.91b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Hainan Haiyao is worth CN¥5.44b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. There's no doubt that we learn most about debt from the balance sheet. But it is Hainan Haiyao's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Over 12 months, Hainan Haiyao made a loss at the EBIT level, and saw its revenue drop to CN¥2.1b, which is a fall of 7.8%. That's not what we would hope to see.

Caveat Emptor

Importantly, Hainan Haiyao had an earnings before interest and tax (EBIT) loss over the last year. Its EBIT loss was a whopping CN¥667m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled CN¥244m in negative free cash flow over the last twelve months. So suffice it to say we do consider the stock to be risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Hainan Haiyao .

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.