The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Haining China Leather Market Co.,Ltd (SZSE:002344) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Haining China Leather MarketLtd

How Much Debt Does Haining China Leather MarketLtd Carry?

As you can see below, at the end of June 2022, Haining China Leather MarketLtd had CN¥1.48b of debt, up from CN¥906.2m a year ago. Click the image for more detail. However, it does have CN¥2.38b in cash offsetting this, leading to net cash of CN¥898.0m.

A Look At Haining China Leather MarketLtd's Liabilities

The latest balance sheet data shows that Haining China Leather MarketLtd had liabilities of CN¥3.64b due within a year, and liabilities of CN¥1.38b falling due after that. Offsetting these obligations, it had cash of CN¥2.38b as well as receivables valued at CN¥562.1m due within 12 months. So its liabilities total CN¥2.08b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Haining China Leather MarketLtd has a market capitalization of CN¥5.22b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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, Haining China Leather MarketLtd also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that Haining China Leather MarketLtd has boosted its EBIT by 41%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Haining China Leather MarketLtd 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Haining China Leather MarketLtd 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. Looking at the most recent three years, Haining China Leather MarketLtd recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While Haining China Leather MarketLtd does have more liabilities than liquid assets, it also has net cash of CN¥898.0m. And we liked the look of last year's 41% year-on-year EBIT growth. So we don't have any problem with Haining China Leather MarketLtd's use of debt. 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 Haining China Leather MarketLtd has 3 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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.