Henan Liliang Diamond (SZSE:301071) Seems To Use Debt Quite Sensibly

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.' 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, Henan Liliang Diamond Co., Ltd. (SZSE:301071) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Henan Liliang Diamond

What Is Henan Liliang Diamond's Net Debt?

As you can see below, at the end of September 2023, Henan Liliang Diamond had CN¥314.8m of debt, up from CN¥270.0m a year ago. Click the image for more detail. However, it does have CN¥4.03b in cash offsetting this, leading to net cash of CN¥3.71b.

How Strong Is Henan Liliang Diamond's Balance Sheet?

We can see from the most recent balance sheet that Henan Liliang Diamond had liabilities of CN¥850.5m falling due within a year, and liabilities of CN¥439.6m due beyond that. Offsetting this, it had CN¥4.03b in cash and CN¥392.0m in receivables that were due within 12 months. So it actually has CN¥3.13b more liquid assets than total liabilities.

This surplus strongly suggests that Henan Liliang Diamond 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. Succinctly put, Henan Liliang Diamond boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Henan Liliang Diamond if management cannot prevent a repeat of the 29% cut to EBIT 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 Henan Liliang Diamond 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Henan Liliang Diamond may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Henan Liliang Diamond burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Henan Liliang Diamond has net cash of CN¥3.71b, as well as more liquid assets than liabilities. So we don't have any problem with Henan Liliang Diamond's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Henan Liliang Diamond (of which 1 shouldn't be ignored!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.