Huaming Power EquipmentLtd (SZSE:002270) Could Easily Take On More Debt

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.' 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 Huaming Power Equipment Co.,Ltd (SZSE:002270) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Huaming Power EquipmentLtd

What Is Huaming Power EquipmentLtd's Debt?

As you can see below, Huaming Power EquipmentLtd had CN¥320.4m of debt at December 2023, down from CN¥503.2m a year prior. But it also has CN¥1.11b in cash to offset that, meaning it has CN¥790.4m net cash.

How Strong Is Huaming Power EquipmentLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Huaming Power EquipmentLtd had liabilities of CN¥740.6m due within 12 months and liabilities of CN¥414.9m due beyond that. Offsetting this, it had CN¥1.11b in cash and CN¥1.36b in receivables that were due within 12 months. So it can boast CN¥1.31b more liquid assets than total liabilities.

This short term liquidity is a sign that Huaming Power EquipmentLtd could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Huaming Power EquipmentLtd 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 Huaming Power EquipmentLtd has boosted its EBIT by 42%, thus reducing the spectre of future debt repayments. 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 Huaming Power EquipmentLtd 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Huaming Power EquipmentLtd 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. During the last three years, Huaming Power EquipmentLtd generated free cash flow amounting to a very robust 90% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Huaming Power EquipmentLtd has net cash of CN¥790.4m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥559m, being 90% of its EBIT. So is Huaming Power EquipmentLtd's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Huaming Power EquipmentLtd you should be aware of.

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.