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.' 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. Importantly, Guangdong Hoshion Industrial Aluminium Co., Ltd. (SZSE:002824) does carry debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Guangdong Hoshion Industrial Aluminium

What Is Guangdong Hoshion Industrial Aluminium's Debt?

As you can see below, at the end of September 2023, Guangdong Hoshion Industrial Aluminium had CN¥607.9m of debt, up from CN¥494.3m a year ago. Click the image for more detail. On the flip side, it has CN¥225.7m in cash leading to net debt of about CN¥382.1m.

A Look At Guangdong Hoshion Industrial Aluminium's Liabilities

Zooming in on the latest balance sheet data, we can see that Guangdong Hoshion Industrial Aluminium had liabilities of CN¥1.14b due within 12 months and liabilities of CN¥392.8m due beyond that. On the other hand, it had cash of CN¥225.7m and CN¥1.20b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥101.7m.

Having regard to Guangdong Hoshion Industrial Aluminium's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥5.76b company is struggling for cash, we still think it's worth monitoring its balance sheet.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Guangdong Hoshion Industrial Aluminium's net debt is only 1.4 times its EBITDA. And its EBIT easily covers its interest expense, being 10.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Guangdong Hoshion Industrial Aluminium's saving grace is its low debt levels, because its EBIT has tanked 22% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Guangdong Hoshion Industrial Aluminium 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Guangdong Hoshion Industrial Aluminium saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Both Guangdong Hoshion Industrial Aluminium's EBIT growth rate and its conversion of EBIT to free cash flow were discouraging. But on the brighter side of life, its interest cover leaves us feeling more frolicsome. Taking the abovementioned factors together we do think Guangdong Hoshion Industrial Aluminium's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Guangdong Hoshion Industrial Aluminium 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.