China Hongguang Holdings (HKG:8646) Has A Rock Solid Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that China Hongguang Holdings Limited (HKG:8646) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for China Hongguang Holdings

How Much Debt Does China Hongguang Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that China Hongguang Holdings had CN¥69.0m of debt in June 2023, down from CN¥76.5m, one year before. But on the other hand it also has CN¥101.4m in cash, leading to a CN¥32.4m net cash position.

How Strong Is China Hongguang Holdings' Balance Sheet?

According to the last reported balance sheet, China Hongguang Holdings had liabilities of CN¥97.1m due within 12 months, and liabilities of CN¥7.53m due beyond 12 months. Offsetting this, it had CN¥101.4m in cash and CN¥66.2m in receivables that were due within 12 months. So it actually has CN¥63.0m more liquid assets than total liabilities.

This excess liquidity is a great indication that China Hongguang Holdings' balance sheet is almost as strong as Fort Knox. Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that China Hongguang Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

Another good sign is that China Hongguang Holdings has been able to increase its EBIT by 21% in twelve months, making it easier to pay down debt. 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 China Hongguang Holdings 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While China Hongguang Holdings 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. During the last three years, China Hongguang Holdings 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 China Hongguang Holdings has net cash of CN¥32.4m, as well as more liquid assets than liabilities. And we liked the look of last year's 21% year-on-year EBIT growth. So is China Hongguang Holdings's debt a risk? It doesn't seem so to us. 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. To that end, you should learn about the 4 warning signs we've spotted with China Hongguang Holdings (including 1 which makes us a bit uncomfortable) .

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.