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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Guangdong Haomei New Materials Co.,Ltd (SZSE:002988) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Guangdong Haomei New MaterialsLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Guangdong Haomei New MaterialsLtd had CN¥2.49b of debt, an increase on CN¥2.29b, over one year. However, it does have CN¥256.3m in cash offsetting this, leading to net debt of about CN¥2.24b.

How Healthy Is Guangdong Haomei New MaterialsLtd's Balance Sheet?

We can see from the most recent balance sheet that Guangdong Haomei New MaterialsLtd had liabilities of CN¥2.24b falling due within a year, and liabilities of CN¥934.1m due beyond that. On the other hand, it had cash of CN¥256.3m and CN¥2.46b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥460.3m.

Since publicly traded Guangdong Haomei New MaterialsLtd shares are worth a total of CN¥4.83b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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 Haomei New MaterialsLtd's debt is 4.8 times its EBITDA, and its EBIT cover its interest expense 3.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, it should be some comfort for shareholders to recall that Guangdong Haomei New MaterialsLtd actually grew its EBIT by a hefty 4,642%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. 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 Haomei New MaterialsLtd 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. During the last three years, Guangdong Haomei New MaterialsLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Guangdong Haomei New MaterialsLtd's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. We think that Guangdong Haomei New MaterialsLtd's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 2 warning signs for Guangdong Haomei New MaterialsLtd (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.