Is Henan Liliang Diamond (SZSE:301071) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Henan Liliang Diamond Co., Ltd. (SZSE:301071) makes use of debt. But the real question is whether this debt is making the company risky.

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When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

What Is Henan Liliang Diamond's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Henan Liliang Diamond had CN¥599.9m of debt, an increase on CN¥314.8m, over one year. However, its balance sheet shows it holds CN¥3.72b in cash, so it actually has CN¥3.12b net cash.

How Strong Is Henan Liliang Diamond's Balance Sheet?

The latest balance sheet data shows that Henan Liliang Diamond had liabilities of CN¥825.1m due within a year, and liabilities of CN¥374.0m falling due after that. Offsetting this, it had CN¥3.72b in cash and CN¥176.9m in receivables that were due within 12 months. So it actually has CN¥2.69b more liquid assets than total liabilities.

This surplus liquidity suggests that Henan Liliang Diamond's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. 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!

See our latest analysis for Henan Liliang Diamond

The modesty of its debt load may become crucial for Henan Liliang Diamond if management cannot prevent a repeat of the 35% 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 it is always sensible to investigate a company's debt, in this case Henan Liliang Diamond has CN¥3.12b in net cash and a decent-looking balance sheet. So we are not troubled with Henan Liliang Diamond's debt use. 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 Henan Liliang Diamond is showing 2 warning signs in our investment analysis , 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.