Here's Why Guangzhou Haozhi IndustrialLtd (SZSE:300503) Has A Meaningful Debt Burden

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 Guangzhou Haozhi Industrial Co.,Ltd. (SZSE:300503) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Guangzhou Haozhi IndustrialLtd

What Is Guangzhou Haozhi IndustrialLtd's Debt?

The chart below, which you can click on for greater detail, shows that Guangzhou Haozhi IndustrialLtd had CN¥701.7m in debt in September 2024; about the same as the year before. On the flip side, it has CN¥44.7m in cash leading to net debt of about CN¥657.1m.

How Healthy Is Guangzhou Haozhi IndustrialLtd's Balance Sheet?

The latest balance sheet data shows that Guangzhou Haozhi IndustrialLtd had liabilities of CN¥909.6m due within a year, and liabilities of CN¥557.1m falling due after that. Offsetting these obligations, it had cash of CN¥44.7m as well as receivables valued at CN¥728.6m due within 12 months. So its liabilities total CN¥693.5m more than the combination of its cash and short-term receivables.

Given Guangzhou Haozhi IndustrialLtd has a market capitalization of CN¥5.79b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about Guangzhou Haozhi IndustrialLtd's net debt to EBITDA ratio of 3.3, we think its super-low interest cover of 2.0 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, the silver lining was that Guangzhou Haozhi IndustrialLtd achieved a positive EBIT of CN¥74m in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Guangzhou Haozhi IndustrialLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Considering the last year, Guangzhou Haozhi IndustrialLtd actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Both Guangzhou Haozhi IndustrialLtd's interest cover and its conversion of EBIT to free cash flow were discouraging. But its not so bad at staying on top of its total liabilities. Taking the abovementioned factors together we do think Guangzhou Haozhi IndustrialLtd's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For example, we've discovered 3 warning signs for Guangzhou Haozhi IndustrialLtd (2 are a bit concerning!) that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.