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. We note that Huabao Flavours & Fragrances Co., Ltd. (SZSE:300741) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Huabao Flavours & Fragrances's Debt?
As you can see below, Huabao Flavours & Fragrances had CN¥268.0m of debt at September 2023, down from CN¥490.0m a year prior. However, it does have CN¥4.79b in cash offsetting this, leading to net cash of CN¥4.52b.
How Healthy Is Huabao Flavours & Fragrances' Balance Sheet?
According to the last reported balance sheet, Huabao Flavours & Fragrances had liabilities of CN¥594.2m due within 12 months, and liabilities of CN¥191.9m due beyond 12 months. Offsetting these obligations, it had cash of CN¥4.79b as well as receivables valued at CN¥524.4m due within 12 months. So it actually has CN¥4.53b more liquid assets than total liabilities.
This surplus liquidity suggests that Huabao Flavours & Fragrances' balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, Huabao Flavours & Fragrances boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact Huabao Flavours & Fragrances's saving grace is its low debt levels, because its EBIT has tanked 57% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Huabao Flavours & Fragrances'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Huabao Flavours & Fragrances 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. Over the last three years, Huabao Flavours & Fragrances actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Huabao Flavours & Fragrances has net cash of CN¥4.52b, as well as more liquid assets than liabilities. The cherry on top was that in converted 108% of that EBIT to free cash flow, bringing in CN¥564m. So is Huabao Flavours & Fragrances's debt a risk? It doesn't seem so to us. 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. For example, we've discovered 3 warning signs for Huabao Flavours & Fragrances (1 is significant!) that you should be aware of before investing here.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.