The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Huazhong In-Vehicle Holdings Company Limited (HKG:6830) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Huazhong In-Vehicle Holdings

What Is Huazhong In-Vehicle Holdings's Debt?

The chart below, which you can click on for greater detail, shows that Huazhong In-Vehicle Holdings had CN¥719.7m in debt in December 2021; about the same as the year before. However, it does have CN¥61.7m in cash offsetting this, leading to net debt of about CN¥658.0m.

How Strong Is Huazhong In-Vehicle Holdings' Balance Sheet?

We can see from the most recent balance sheet that Huazhong In-Vehicle Holdings had liabilities of CN¥1.87b falling due within a year, and liabilities of CN¥199.3m due beyond that. On the other hand, it had cash of CN¥61.7m and CN¥859.9m worth of receivables due within a year. So its liabilities total CN¥1.15b more than the combination of its cash and short-term receivables.

Huazhong In-Vehicle Holdings has a market capitalization of CN¥4.42b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Huazhong In-Vehicle Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (5.1), and fairly weak interest coverage, since EBIT is just 0.87 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Huazhong In-Vehicle Holdings's EBIT was down 79% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Huazhong In-Vehicle Holdings 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Huazhong In-Vehicle Holdings reported free cash flow worth 19% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Huazhong In-Vehicle Holdings's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to handle its total liabilities isn't such a worry. We're quite clear that we consider Huazhong In-Vehicle Holdings to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Huazhong In-Vehicle Holdings you should be aware of, and 2 of them are a bit concerning.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.