We Think Huafon Chemical (SZSE:002064) Can Stay On Top Of Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. We note that Huafon Chemical Co., Ltd. (SZSE:002064) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Huafon Chemical

How Much Debt Does Huafon Chemical Carry?

As you can see below, at the end of September 2023, Huafon Chemical had CN¥6.54b of debt, up from CN¥4.43b a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥11.9b in cash, so it actually has CN¥5.35b net cash.

How Healthy Is Huafon Chemical's Balance Sheet?

We can see from the most recent balance sheet that Huafon Chemical had liabilities of CN¥11.4b falling due within a year, and liabilities of CN¥1.68b due beyond that. Offsetting these obligations, it had cash of CN¥11.9b as well as receivables valued at CN¥6.00b due within 12 months. So it can boast CN¥4.82b more liquid assets than total liabilities.

This surplus suggests that Huafon Chemical has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Huafon Chemical boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Huafon Chemical's load is not too heavy, because its EBIT was down 54% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Huafon Chemical 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Huafon Chemical has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, Huafon Chemical recorded free cash flow of 28% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Huafon Chemical has CN¥5.35b in net cash and a decent-looking balance sheet. So we don't have any problem with Huafon Chemical's use of debt. 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. We've identified 3 warning signs with Huafon Chemical (at least 1 which is potentially serious) , 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.