Is Huafu Fashion (SZSE:002042) Weighed On By Its Debt Load?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Huafu Fashion

How Much Debt Does Huafu Fashion Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Huafu Fashion had debt of CN¥8.70b, up from CN¥8.16b in one year. However, it does have CN¥2.81b in cash offsetting this, leading to net debt of about CN¥5.90b.

How Strong Is Huafu Fashion's Balance Sheet?

The latest balance sheet data shows that Huafu Fashion had liabilities of CN¥10.2b due within a year, and liabilities of CN¥1.13b falling due after that. On the other hand, it had cash of CN¥2.81b and CN¥1.60b worth of receivables due within a year. So its liabilities total CN¥6.93b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CN¥6.33b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Huafu Fashion can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Over 12 months, Huafu Fashion made a loss at the EBIT level, and saw its revenue drop to CN¥13b, which is a fall of 12%. We would much prefer see growth.

Caveat Emptor

Not only did Huafu Fashion's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at CN¥64m. Considering that alongside the liabilities mentioned above make us nervous about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it had negative free cash flow of CN¥447m over the last twelve months. So suffice it to say we consider the stock to be risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Huafu Fashion has 2 warning signs (and 1 which is potentially serious) we think 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com