Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Hangzhou Huawang New Material Technology Co.,Ltd. (SHSE:605377) does have debt on its balance sheet. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Hangzhou Huawang New Material TechnologyLtd Carry?
You can click the graphic below for the historical numbers, but it shows that Hangzhou Huawang New Material TechnologyLtd had CN¥62.2m of debt in March 2024, down from CN¥314.0m, one year before. However, its balance sheet shows it holds CN¥1.72b in cash, so it actually has CN¥1.66b net cash.
A Look At Hangzhou Huawang New Material TechnologyLtd's Liabilities
Zooming in on the latest balance sheet data, we can see that Hangzhou Huawang New Material TechnologyLtd had liabilities of CN¥1.54b due within 12 months and liabilities of CN¥83.0m due beyond that. Offsetting these obligations, it had cash of CN¥1.72b as well as receivables valued at CN¥1.65b due within 12 months. So it can boast CN¥1.75b more liquid assets than total liabilities.
This surplus suggests that Hangzhou Huawang New Material TechnologyLtd is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that Hangzhou Huawang New Material TechnologyLtd has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that Hangzhou Huawang New Material TechnologyLtd has boosted its EBIT by 43%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Hangzhou Huawang New Material TechnologyLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Hangzhou Huawang New Material TechnologyLtd may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Hangzhou Huawang New Material TechnologyLtd's free cash flow amounted to 23% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Hangzhou Huawang New Material TechnologyLtd has net cash of CN¥1.66b, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 43% over the last year. So we don't think Hangzhou Huawang New Material TechnologyLtd's use of debt is risky. 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. Case in point: We've spotted 2 warning signs for Hangzhou Huawang New Material TechnologyLtd you should be aware of, and 1 of them is concerning.
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.