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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Hua Hong Semiconductor Limited (HKG:1347) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Hua Hong Semiconductor's Debt?

As you can see below, at the end of December 2023, Hua Hong Semiconductor had US$2.10b of debt, up from US$1.91b a year ago. Click the image for more detail. But on the other hand it also has US$5.59b in cash, leading to a US$3.49b net cash position.

How Healthy Is Hua Hong Semiconductor's Balance Sheet?

We can see from the most recent balance sheet that Hua Hong Semiconductor had liabilities of US$972.4m falling due within a year, and liabilities of US$1.96b due beyond that. On the other hand, it had cash of US$5.59b and US$301.5m worth of receivables due within a year. So it actually has US$2.96b more liquid assets than total liabilities.

This surplus liquidity suggests that Hua Hong Semiconductor's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that Hua Hong Semiconductor has more cash than debt is arguably a good indication that it can manage its debt safely.

Shareholders should be aware that Hua Hong Semiconductor's EBIT was down 73% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hua Hong Semiconductor 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. Hua Hong Semiconductor 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. During the last three years, Hua Hong Semiconductor burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Hua Hong Semiconductor has net cash of US$3.49b, as well as more liquid assets than liabilities. So we are not troubled with Hua Hong Semiconductor's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Hua Hong Semiconductor that you should be aware of.

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.