Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Fufeng Group Limited (HKG:546) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Fufeng Group

What Is Fufeng Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Fufeng Group had CN¥7.73b of debt, an increase on CN¥3.52b, over one year. But on the other hand it also has CN¥8.02b in cash, leading to a CN¥287.9m net cash position.

A Look At Fufeng Group's Liabilities

The latest balance sheet data shows that Fufeng Group had liabilities of CN¥8.71b due within a year, and liabilities of CN¥3.70b falling due after that. Offsetting these obligations, it had cash of CN¥8.02b as well as receivables valued at CN¥1.64b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.75b.

Fufeng Group has a market capitalization of CN¥9.21b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Fufeng Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

Even more impressive was the fact that Fufeng Group grew its EBIT by 175% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Fufeng Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Fufeng Group 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. Looking at the most recent three years, Fufeng Group recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

Although Fufeng Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥287.9m. And it impressed us with its EBIT growth of 175% over the last year. So we are not troubled with Fufeng Group's debt use. 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. Be aware that Fufeng Group is showing 1 warning sign in our investment analysis , you should know about...

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.