David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Hengan International Group Company Limited (HKG:1044) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hengan International Group

What Is Hengan International Group's Net Debt?

As you can see below, Hengan International Group had CN¥22.9b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥24.5b in cash offsetting this, leading to net cash of CN¥1.63b.

How Strong Is Hengan International Group's Balance Sheet?

We can see from the most recent balance sheet that Hengan International Group had liabilities of CN¥24.8b falling due within a year, and liabilities of CN¥2.31b due beyond that. Offsetting these obligations, it had cash of CN¥24.5b as well as receivables valued at CN¥4.89b due within 12 months. So it can boast CN¥2.26b more liquid assets than total liabilities.

This surplus suggests that Hengan International Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Hengan International Group has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Hengan International Group if management cannot prevent a repeat of the 32% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Hengan International Group 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, a company can only pay off debt with cold hard cash, not accounting profits. Hengan International Group 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, Hengan International Group generated free cash flow amounting to a very robust 90% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Hengan International Group has net cash of CN¥1.63b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥3.7b, being 90% of its EBIT. So we are not troubled with Hengan International Group's debt use. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Hengan International Group that you should be aware of.

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.