Hongfa Technology (SHSE:600885) Has A Pretty Healthy Balance Sheet

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Hongfa Technology Co., Ltd. (SHSE:600885) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for Hongfa Technology

How Much Debt Does Hongfa Technology Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Hongfa Technology had CN¥3.91b of debt, an increase on CN¥2.91b, over one year. However, it does have CN¥3.72b in cash offsetting this, leading to net debt of about CN¥193.7m.

How Healthy Is Hongfa Technology's Balance Sheet?

We can see from the most recent balance sheet that Hongfa Technology had liabilities of CN¥4.98b falling due within a year, and liabilities of CN¥3.41b due beyond that. Offsetting this, it had CN¥3.72b in cash and CN¥5.96b in receivables that were due within 12 months. So it can boast CN¥1.29b more liquid assets than total liabilities.

This surplus suggests that Hongfa Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Carrying virtually no net debt, Hongfa Technology has a very light debt load indeed.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With debt at a measly 0.06 times EBITDA and EBIT covering interest a whopping 25.5 times, it's clear that Hongfa Technology is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. The good news is that Hongfa Technology has increased its EBIT by 9.1% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hongfa Technology can strengthen its balance sheet over time. 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Hongfa Technology's free cash flow amounted to 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Hongfa Technology's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Taking all this data into account, it seems to us that Hongfa Technology takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. Be aware that Hongfa Technology is showing 1 warning sign in our investment analysis , you should know about...

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.