Is Shanghai Huayi Group (SHSE:600623) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Shanghai Huayi Group Corporation Limited (SHSE:600623) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Shanghai Huayi Group

What Is Shanghai Huayi Group's Net Debt?

The chart below, which you can click on for greater detail, shows that Shanghai Huayi Group had CN¥12.7b in debt in September 2024; about the same as the year before. However, its balance sheet shows it holds CN¥17.2b in cash, so it actually has CN¥4.54b net cash.

How Strong Is Shanghai Huayi Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Huayi Group had liabilities of CN¥26.0b due within 12 months and liabilities of CN¥8.95b due beyond that. Offsetting these obligations, it had cash of CN¥17.2b as well as receivables valued at CN¥3.53b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥14.2b.

Given this deficit is actually higher than the company's market capitalization of CN¥14.1b, we think shareholders really should watch Shanghai Huayi Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Given that Shanghai Huayi Group has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

Better yet, Shanghai Huayi Group grew its EBIT by 200% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shanghai Huayi Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Shanghai Huayi Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Shanghai Huayi Group produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

Although Shanghai Huayi Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥4.54b. And it impressed us with its EBIT growth of 200% over the last year. So we don't have any problem with Shanghai Huayi Group's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Shanghai Huayi Group , and understanding them should be part of your investment process.

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.