Is Hwa Create (SZSE:300045) Using Too Much 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.' 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 Hwa Create Corporation (SZSE:300045) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Hwa Create

How Much Debt Does Hwa Create Carry?

As you can see below, at the end of March 2024, Hwa Create had CN¥73.4m of debt, up from CN¥43.8m a year ago. Click the image for more detail. However, it does have CN¥318.1m in cash offsetting this, leading to net cash of CN¥244.7m.

A Look At Hwa Create's Liabilities

We can see from the most recent balance sheet that Hwa Create had liabilities of CN¥611.9m falling due within a year, and liabilities of CN¥123.2m due beyond that. Offsetting this, it had CN¥318.1m in cash and CN¥660.6m in receivables that were due within 12 months. So it actually has CN¥243.7m more liquid assets than total liabilities.

This surplus suggests that Hwa Create has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Hwa Create has more cash than debt is arguably a good indication that it can manage its debt safely.

Although Hwa Create made a loss at the EBIT level, last year, it was also good to see that it generated CN¥16m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hwa Create's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Hwa Create 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. Over the last year, Hwa Create actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While it is always sensible to investigate a company's debt, in this case Hwa Create has CN¥244.7m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥24m, being 150% of its EBIT. So is Hwa Create's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Hwa Create you should know about.

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.