Does Huabao Flavours & Fragrances (SZSE:300741) 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. Importantly, Huabao Flavours & Fragrances Co., Ltd. (SZSE:300741) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Huabao Flavours & Fragrances

What Is Huabao Flavours & Fragrances's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Huabao Flavours & Fragrances had CN¥268.0m of debt in September 2023, down from CN¥490.0m, one year before. However, it does have CN¥4.79b in cash offsetting this, leading to net cash of CN¥4.52b.

A Look At Huabao Flavours & Fragrances' Liabilities

We can see from the most recent balance sheet that Huabao Flavours & Fragrances had liabilities of CN¥594.2m falling due within a year, and liabilities of CN¥191.9m due beyond that. Offsetting this, it had CN¥4.79b in cash and CN¥524.4m in receivables that were due within 12 months. So it can boast CN¥4.53b more liquid assets than total liabilities.

This surplus strongly suggests that Huabao Flavours & Fragrances has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Huabao Flavours & Fragrances has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Huabao Flavours & Fragrances's saving grace is its low debt levels, because its EBIT has tanked 57% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Huabao Flavours & Fragrances will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Huabao Flavours & Fragrances 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. Over the last three years, Huabao Flavours & Fragrances actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While it is always sensible to investigate a company's debt, in this case Huabao Flavours & Fragrances has CN¥4.52b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 108% of that EBIT to free cash flow, bringing in CN¥564m. So we don't think Huabao Flavours & Fragrances's use of debt is risky. 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 instance, we've identified 3 warning signs for Huabao Flavours & Fragrances (1 shouldn't be ignored) 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.