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.' 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 Shanghai Huayi Group Corporation Limited (SHSE:600623) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Shanghai Huayi Group Carry?

The image below, which you can click on for greater detail, shows that at September 2023 Shanghai Huayi Group had debt of CN¥12.5b, up from CN¥10.1b in one year. But it also has CN¥16.4b in cash to offset that, meaning it has CN¥3.96b net cash.

How Healthy Is Shanghai Huayi Group's Balance Sheet?

According to the last reported balance sheet, Shanghai Huayi Group had liabilities of CN¥25.7b due within 12 months, and liabilities of CN¥10.3b due beyond 12 months. Offsetting this, it had CN¥16.4b in cash and CN¥5.01b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥14.6b.

Given this deficit is actually higher than the company's market capitalization of CN¥10.6b, we think shareholders really should watch Shanghai Huayi Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Shanghai Huayi Group boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

The modesty of its debt load may become crucial for Shanghai Huayi Group if management cannot prevent a repeat of the 88% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shanghai Huayi Group will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Shanghai Huayi Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Shanghai Huayi Group created free cash flow amounting to 19% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

Although Shanghai Huayi Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥3.96b. Despite its cash we think that Shanghai Huayi Group seems to struggle to grow its EBIT, so we are wary of the stock. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Shanghai Huayi Group 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.