Shanghai Huafon Aluminium (SHSE:601702) Seems To Use Debt Rather Sparingly

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Shanghai Huafon Aluminium Corporation (SHSE:601702) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. 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.

Check out our latest analysis for Shanghai Huafon Aluminium

How Much Debt Does Shanghai Huafon Aluminium Carry?

As you can see below, Shanghai Huafon Aluminium had CN¥1.54b of debt at June 2024, down from CN¥1.79b a year prior. However, it also had CN¥360.9m in cash, and so its net debt is CN¥1.18b.

A Look At Shanghai Huafon Aluminium's Liabilities

Zooming in on the latest balance sheet data, we can see that Shanghai Huafon Aluminium had liabilities of CN¥2.00b due within 12 months and liabilities of CN¥197.1m due beyond that. On the other hand, it had cash of CN¥360.9m and CN¥2.51b worth of receivables due within a year. So it can boast CN¥670.8m 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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Shanghai Huafon Aluminium has a low net debt to EBITDA ratio of only 0.85. And its EBIT easily covers its interest expense, being 25.8 times the size. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Shanghai Huafon Aluminium has boosted its EBIT by 44%, thus reducing the spectre of future debt repayments. 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 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Shanghai Huafon Aluminium recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Shanghai Huafon Aluminium's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think Shanghai Huafon Aluminium's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Shanghai Huafon Aluminium is showing 1 warning sign in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.