Does Huafon Microfibre (Shanghai) (SZSE:300180) Have A Healthy Balance Sheet?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Huafon Microfibre (Shanghai) Co., Ltd. (SZSE:300180) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Huafon Microfibre (Shanghai)

What Is Huafon Microfibre (Shanghai)'s Debt?

You can click the graphic below for the historical numbers, but it shows that Huafon Microfibre (Shanghai) had CN¥1.71b of debt in September 2024, down from CN¥2.29b, one year before. However, it does have CN¥435.4m in cash offsetting this, leading to net debt of about CN¥1.28b.

A Look At Huafon Microfibre (Shanghai)'s Liabilities

The latest balance sheet data shows that Huafon Microfibre (Shanghai) had liabilities of CN¥1.87b due within a year, and liabilities of CN¥597.6m falling due after that. Offsetting these obligations, it had cash of CN¥435.4m as well as receivables valued at CN¥998.8m due within 12 months. So its liabilities total CN¥1.03b more than the combination of its cash and short-term receivables.

Of course, Huafon Microfibre (Shanghai) has a market capitalization of CN¥14.0b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

While we wouldn't worry about Huafon Microfibre (Shanghai)'s net debt to EBITDA ratio of 2.6, we think its super-low interest cover of 0.31 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, the silver lining was that Huafon Microfibre (Shanghai) achieved a positive EBIT of CN¥14m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Huafon Microfibre (Shanghai) will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Huafon Microfibre (Shanghai) actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Based on what we've seen Huafon Microfibre (Shanghai) is not finding it easy, given its interest cover, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. Considering this range of data points, we think Huafon Microfibre (Shanghai) is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example, we've discovered 2 warning signs for Huafon Microfibre (Shanghai) that you should be aware of before investing here.

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.