Is Shanghai Huafon Aluminium (SHSE:601702) A Risky Investment?

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.' 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. We note that Shanghai Huafon Aluminium Corporation (SHSE:601702) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Shanghai Huafon Aluminium

What Is Shanghai Huafon Aluminium's Debt?

The image below, which you can click on for greater detail, shows that Shanghai Huafon Aluminium had debt of CN¥1.83b at the end of March 2024, a reduction from CN¥1.93b over a year. However, it also had CN¥568.5m in cash, and so its net debt is CN¥1.26b.

A Look At Shanghai Huafon Aluminium's Liabilities

We can see from the most recent balance sheet that Shanghai Huafon Aluminium had liabilities of CN¥2.42b falling due within a year, and liabilities of CN¥198.7m due beyond that. On the other hand, it had cash of CN¥568.5m and CN¥2.83b worth of receivables due within a year. So it can boast CN¥783.0m more liquid assets than total liabilities.

This surplus suggests that Shanghai Huafon Aluminium has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shanghai Huafon Aluminium has a low net debt to EBITDA ratio of only 0.98. And its EBIT easily covers its interest expense, being 22.4 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Shanghai Huafon Aluminium grew its EBIT by 31% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shanghai Huafon Aluminium 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Shanghai Huafon Aluminium recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that Shanghai Huafon Aluminium's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, Shanghai Huafon Aluminium seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. For example - Shanghai Huafon Aluminium has 1 warning sign we think you should be aware of.

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.