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. We can see that Health and Happiness (H&H) International Holdings Limited (HKG:1112) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. 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.

View our latest analysis for Health and Happiness (H&H) International Holdings

What Is Health and Happiness (H&H) International Holdings's Net Debt?

As you can see below, at the end of December 2021, Health and Happiness (H&H) International Holdings had CN¥9.58b of debt, up from CN¥6.54b a year ago. Click the image for more detail. On the flip side, it has CN¥2.41b in cash leading to net debt of about CN¥7.17b.

How Healthy Is Health and Happiness (H&H) International Holdings' Balance Sheet?

We can see from the most recent balance sheet that Health and Happiness (H&H) International Holdings had liabilities of CN¥6.82b falling due within a year, and liabilities of CN¥7.57b due beyond that. Offsetting these obligations, it had cash of CN¥2.41b as well as receivables valued at CN¥835.2m due within 12 months. So it has liabilities totalling CN¥11.2b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥5.34b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Health and Happiness (H&H) International Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Health and Happiness (H&H) International Holdings's debt is 4.6 times its EBITDA, and its EBIT cover its interest expense 4.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Shareholders should be aware that Health and Happiness (H&H) International Holdings's EBIT was down 24% 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. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Health and Happiness (H&H) International Holdings's ability to maintain a healthy balance sheet going forward. 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. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Health and Happiness (H&H) International Holdings generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

To be frank both Health and Happiness (H&H) International Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Health and Happiness (H&H) International Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 4 warning signs for Health and Happiness (H&H) International Holdings (1 is significant!) that you should be aware of before investing here.

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.