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. We note that Health and Happiness (H&H) International Holdings Limited (HKG:1112) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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, 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.

View our latest analysis for Health and Happiness (H&H) International Holdings

What Is Health and Happiness (H&H) International Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Health and Happiness (H&H) International Holdings had CN¥9.36b of debt, an increase on CN¥6.35b, over one year. However, it also had CN¥2.11b in cash, and so its net debt is CN¥7.25b.

How Strong Is Health and Happiness (H&H) International Holdings' Balance Sheet?

The latest balance sheet data shows that Health and Happiness (H&H) International Holdings had liabilities of CN¥3.75b due within a year, and liabilities of CN¥10.0b falling due after that. Offsetting this, it had CN¥2.11b in cash and CN¥687.9m in receivables that were due within 12 months. So its liabilities total CN¥11.0b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥5.60b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Health and Happiness (H&H) International Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Health and Happiness (H&H) International Holdings's debt is 4.5 times its EBITDA, and its EBIT cover its interest expense 3.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Investors should also be troubled by the fact that Health and Happiness (H&H) International Holdings saw its EBIT drop by 11% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Health and Happiness (H&H) International Holdings 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Health and Happiness (H&H) International Holdings recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Mulling over Health and Happiness (H&H) International Holdings's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We're quite clear that we consider Health and Happiness (H&H) International Holdings to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. We've identified 3 warning signs with Health and Happiness (H&H) International Holdings , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.