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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Hisense Home Appliances Group Co., Ltd. (SZSE:000921) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hisense Home Appliances Group

How Much Debt Does Hisense Home Appliances Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Hisense Home Appliances Group had CN¥3.13b of debt, an increase on CN¥500.6m, over one year. However, it does have CN¥14.7b in cash offsetting this, leading to net cash of CN¥11.6b.

How Strong Is Hisense Home Appliances Group's Balance Sheet?

We can see from the most recent balance sheet that Hisense Home Appliances Group had liabilities of CN¥37.1b falling due within a year, and liabilities of CN¥2.28b due beyond that. On the other hand, it had cash of CN¥14.7b and CN¥14.0b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥10.7b.

This is a mountain of leverage relative to its market capitalization of CN¥14.7b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Hisense Home Appliances Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact Hisense Home Appliances Group's saving grace is its low debt levels, because its EBIT has tanked 29% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hisense Home Appliances Group's ability to maintain a healthy balance sheet going forward. 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. Hisense Home Appliances Group 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, Hisense Home Appliances Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While Hisense Home Appliances Group does have more liabilities than liquid assets, it also has net cash of CN¥11.6b. And it impressed us with free cash flow of CN¥3.1b, being 166% of its EBIT. So we are not troubled with Hisense Home Appliances Group's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Hisense Home Appliances Group you should be aware of.

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.