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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Hainan Haiyao Co., Ltd. (SZSE:000566) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Hainan Haiyao

How Much Debt Does Hainan Haiyao Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Hainan Haiyao had CN¥3.93b of debt, an increase on CN¥2.86b, over one year. However, it also had CN¥962.3m in cash, and so its net debt is CN¥2.97b.

How Healthy Is Hainan Haiyao's Balance Sheet?

The latest balance sheet data shows that Hainan Haiyao had liabilities of CN¥3.97b due within a year, and liabilities of CN¥1.46b falling due after that. Offsetting this, it had CN¥962.3m in cash and CN¥1.57b in receivables that were due within 12 months. So its liabilities total CN¥2.89b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Hainan Haiyao has a market capitalization of CN¥5.71b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. There's no doubt that we learn most about debt from the balance sheet. But it is Hainan Haiyao's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Hainan Haiyao had a loss before interest and tax, and actually shrunk its revenue by 2.9%, to CN¥2.1b. We would much prefer see growth.

Caveat Emptor

Importantly, Hainan Haiyao had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost CN¥545m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled CN¥178m in negative free cash flow over the last twelve months. So suffice it to say we do consider the stock to be risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Hainan Haiyao 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.