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. As with many other companies Henan Liliang Diamond Co., Ltd. (SZSE:301071) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Henan Liliang Diamond's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Henan Liliang Diamond had CN¥314.8m of debt, an increase on CN¥270.0m, over one year. However, its balance sheet shows it holds CN¥4.03b in cash, so it actually has CN¥3.71b net cash.

How Strong Is Henan Liliang Diamond's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Henan Liliang Diamond had liabilities of CN¥850.5m due within 12 months and liabilities of CN¥439.6m due beyond that. Offsetting these obligations, it had cash of CN¥4.03b as well as receivables valued at CN¥392.0m due within 12 months. So it can boast CN¥3.13b more liquid assets than total liabilities.

This surplus liquidity suggests that Henan Liliang Diamond's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that Henan Liliang Diamond has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Henan Liliang Diamond if management cannot prevent a repeat of the 29% cut to EBIT over the last year. 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 ultimately the future profitability of the business will decide if Henan Liliang Diamond 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. While Henan Liliang Diamond 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. During the last three years, Henan Liliang Diamond burned a lot of cash. 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.

Summing Up

While it is always sensible to investigate a company's debt, in this case Henan Liliang Diamond has CN¥3.71b in net cash and a decent-looking balance sheet. So we don't have any problem with Henan Liliang Diamond's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Henan Liliang Diamond has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.