These 4 Measures Indicate That Jiangsu HuaxicunLtd (SZSE:000936) Is Using Debt Extensively

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 Jiangsu Huaxicun Co.,Ltd. (SZSE:000936) 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 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 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Jiangsu HuaxicunLtd

How Much Debt Does Jiangsu HuaxicunLtd Carry?

As you can see below, Jiangsu HuaxicunLtd had CN¥1.05b of debt at September 2024, down from CN¥1.11b a year prior. However, because it has a cash reserve of CN¥734.5m, its net debt is less, at about CN¥314.7m.

How Healthy Is Jiangsu HuaxicunLtd's Balance Sheet?

We can see from the most recent balance sheet that Jiangsu HuaxicunLtd had liabilities of CN¥1.34b falling due within a year, and liabilities of CN¥46.1m due beyond that. Offsetting this, it had CN¥734.5m in cash and CN¥397.9m in receivables that were due within 12 months. So it has liabilities totalling CN¥250.3m more than its cash and near-term receivables, combined.

Of course, Jiangsu HuaxicunLtd has a market capitalization of CN¥7.09b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Jiangsu HuaxicunLtd's net debt to EBITDA ratio of about 2.4 suggests only moderate use of debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. The bad news is that Jiangsu HuaxicunLtd saw its EBIT decline by 19% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. But it is Jiangsu HuaxicunLtd'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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Jiangsu HuaxicunLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Neither Jiangsu HuaxicunLtd's ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Jiangsu HuaxicunLtd is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 3 warning signs for Jiangsu HuaxicunLtd (1 is significant!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.