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.' 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. We note that Changhong Huayi Compressor Co., Ltd. (SZSE:000404) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Changhong Huayi Compressor's Debt?
The image below, which you can click on for greater detail, shows that at March 2024 Changhong Huayi Compressor had debt of CN¥2.49b, up from CN¥1.99b in one year. But on the other hand it also has CN¥5.86b in cash, leading to a CN¥3.38b net cash position.
A Look At Changhong Huayi Compressor's Liabilities
Zooming in on the latest balance sheet data, we can see that Changhong Huayi Compressor had liabilities of CN¥8.95b due within 12 months and liabilities of CN¥689.7m due beyond that. Offsetting these obligations, it had cash of CN¥5.86b as well as receivables valued at CN¥3.87b due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
This state of affairs indicates that Changhong Huayi Compressor's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥5.12b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Changhong Huayi Compressor has more cash than debt is arguably a good indication that it can manage its debt safely.
Also positive, Changhong Huayi Compressor grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Changhong Huayi Compressor 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Changhong Huayi Compressor 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. Happily for any shareholders, Changhong Huayi Compressor actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Changhong Huayi Compressor has net cash of CN¥3.38b, as well as more liquid assets than liabilities. The cherry on top was that in converted 200% of that EBIT to free cash flow, bringing in CN¥512m. So we don't think Changhong Huayi Compressor's use of debt is risky. 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. We've identified 1 warning sign with Changhong Huayi Compressor , and understanding them should be part of your investment process.
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.