The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Huagong Tech Company Limited (SZSE:000988) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

What Is Huagong Tech's Net Debt?

The image below, which you can click on for greater detail, shows that Huagong Tech had debt of CN¥2.70b at the end of December 2023, a reduction from CN¥2.95b over a year. However, its balance sheet shows it holds CN¥4.52b in cash, so it actually has CN¥1.82b net cash.

A Look At Huagong Tech's Liabilities

The latest balance sheet data shows that Huagong Tech had liabilities of CN¥5.43b due within a year, and liabilities of CN¥2.81b falling due after that. Offsetting this, it had CN¥4.52b in cash and CN¥5.01b in receivables that were due within 12 months. So it actually has CN¥1.30b more liquid assets than total liabilities.

This surplus suggests that Huagong Tech has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Huagong Tech has more cash than debt is arguably a good indication that it can manage its debt safely.

The good news is that Huagong Tech has increased its EBIT by 9.3% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Huagong Tech 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 company can only pay off debt with cold hard cash, not accounting profits. While Huagong Tech has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Huagong Tech produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case Huagong Tech has CN¥1.82b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥1.1b, being 72% of its EBIT. So is Huagong Tech's debt a risk? It doesn't seem so to us. Over time, share prices tend to follow earnings per share, so if you're interested in Huagong Tech, you may well want to click here to check an interactive graph of its earnings per share history.

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.