Is Dongguan Huali IndustriesLtd (SHSE:603038) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Dongguan Huali Industries Co.,Ltd (SHSE:603038) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Dongguan Huali IndustriesLtd

What Is Dongguan Huali IndustriesLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that Dongguan Huali IndustriesLtd had CN¥303.1m of debt in September 2024, down from CN¥469.5m, one year before. However, because it has a cash reserve of CN¥238.4m, its net debt is less, at about CN¥64.7m.

How Healthy Is Dongguan Huali IndustriesLtd's Balance Sheet?

The latest balance sheet data shows that Dongguan Huali IndustriesLtd had liabilities of CN¥180.1m due within a year, and liabilities of CN¥315.1m falling due after that. Offsetting this, it had CN¥238.4m in cash and CN¥137.2m in receivables that were due within 12 months. So it has liabilities totalling CN¥119.7m more than its cash and near-term receivables, combined.

Given Dongguan Huali IndustriesLtd has a market capitalization of CN¥5.25b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Dongguan Huali IndustriesLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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.

Dongguan Huali IndustriesLtd has a very low debt to EBITDA ratio of 0.70 so it is strange to see weak interest coverage, with last year's EBIT being only 2.1 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Shareholders should be aware that Dongguan Huali IndustriesLtd's EBIT was down 24% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Dongguan Huali IndustriesLtd 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Dongguan Huali IndustriesLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Dongguan Huali IndustriesLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Once we consider all the factors above, together, it seems to us that Dongguan Huali IndustriesLtd's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 3 warning signs for Dongguan Huali IndustriesLtd you should be aware of, and 2 of them are potentially serious.

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.