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.' 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. We note that Shanghai Huafon Aluminium Corporation (SHSE:601702) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Net Debt?

The image below, which you can click on for greater detail, shows that Shanghai Huafon Aluminium had debt of CN¥1.57b at the end of September 2024, a reduction from CN¥1.85b over a year. However, it does have CN¥545.1m in cash offsetting this, leading to net debt of about CN¥1.03b.

How Strong Is Shanghai Huafon Aluminium's Balance Sheet?

We can see from the most recent balance sheet that Shanghai Huafon Aluminium had liabilities of CN¥1.93b falling due within a year, and liabilities of CN¥451.6m due beyond that. Offsetting these obligations, it had cash of CN¥545.1m as well as receivables valued at CN¥2.59b due within 12 months. So it actually has CN¥745.2m 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shanghai Huafon Aluminium's net debt is only 0.69 times its EBITDA. And its EBIT easily covers its interest expense, being 28.4 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Shanghai Huafon Aluminium has boosted its EBIT by 38%, thus reducing the spectre of future debt repayments. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Shanghai Huafon Aluminium produced sturdy free cash flow equating to 57% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Shanghai Huafon Aluminium's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Considering this range of factors, it seems to us that Shanghai Huafon Aluminium is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. Over time, share prices tend to follow earnings per share, so if you're interested in Shanghai Huafon Aluminium, you may well want to click here to check an interactive graph of its earnings per share history.

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.