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.' 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. As with many other companies Hainan Haiyao Co., Ltd. (SZSE:000566) makes use of debt. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Hainan Haiyao

What Is Hainan Haiyao's Debt?

As you can see below, Hainan Haiyao had CN¥4.40b of debt, at March 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥1.18b in cash, and so its net debt is CN¥3.22b.

How Healthy Is Hainan Haiyao's Balance Sheet?

We can see from the most recent balance sheet that Hainan Haiyao had liabilities of CN¥3.98b falling due within a year, and liabilities of CN¥1.37b due beyond that. On the other hand, it had cash of CN¥1.18b and CN¥1.22b worth of receivables due within a year. So it has liabilities totalling CN¥2.95b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Hainan Haiyao has a market capitalization of CN¥5.83b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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 you can't view debt in total isolation; since Hainan Haiyao will need earnings to service that debt. 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¥1.7b, which is a fall of 17%. We would much prefer see growth.

Caveat Emptor

While Hainan Haiyao's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost CN¥123m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled CN¥143m in negative free cash flow over the last twelve months. So suffice it to say we do consider the stock to be risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Hainan Haiyao (at least 1 which is concerning) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.