Here's Why Huafu Fashion (SZSE:002042) Can Afford Some Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Huafu Fashion Co., Ltd. (SZSE:002042) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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.

Check out our latest analysis for Huafu Fashion

How Much Debt Does Huafu Fashion Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Huafu Fashion had CN¥9.17b of debt, an increase on CN¥7.99b, over one year. However, it does have CN¥4.02b in cash offsetting this, leading to net debt of about CN¥5.15b.

A Look At Huafu Fashion's Liabilities

The latest balance sheet data shows that Huafu Fashion had liabilities of CN¥9.91b due within a year, and liabilities of CN¥1.13b falling due after that. Offsetting these obligations, it had cash of CN¥4.02b as well as receivables valued at CN¥1.15b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.89b.

This deficit is considerable relative to its market capitalization of CN¥8.01b, so it does suggest shareholders should keep an eye on Huafu Fashion's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. 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 Huafu Fashion can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

In the last year Huafu Fashion had a loss before interest and tax, and actually shrunk its revenue by 2.2%, to CN¥12b. We would much prefer see growth.

Caveat Emptor

Importantly, Huafu Fashion had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost CN¥107m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. However, it doesn't help that it burned through CN¥599m of cash over the last year. So suffice it to say we consider the stock very risky. 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. Be aware that Huafu Fashion is showing 3 warning signs in our investment analysis , and 2 of those make us uncomfortable...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.