These 4 Measures Indicate That Hengan International Group (HKG:1044) Is Using Debt Reasonably Well

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Hengan International Group Company Limited (HKG:1044) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hengan International Group

What Is Hengan International Group's Debt?

You can click the graphic below for the historical numbers, but it shows that Hengan International Group had CN¥17.0b of debt in December 2022, down from CN¥18.2b, one year before. However, it does have CN¥18.7b in cash offsetting this, leading to net cash of CN¥1.64b.

How Strong Is Hengan International Group's Balance Sheet?

According to the last reported balance sheet, Hengan International Group had liabilities of CN¥20.4b due within 12 months, and liabilities of CN¥2.17b due beyond 12 months. On the other hand, it had cash of CN¥18.7b and CN¥4.89b worth of receivables due within a year. So it can boast CN¥1.00b more liquid assets than total liabilities.

This short term liquidity is a sign that Hengan International Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Hengan International Group has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Hengan International Group's saving grace is its low debt levels, because its EBIT has tanked 23% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hengan International Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Hengan International Group 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, Hengan International Group generated free cash flow amounting to a very robust 99% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to investigate a company's debt, in this case Hengan International Group has CN¥1.64b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 99% of that EBIT to free cash flow, bringing in CN¥3.7b. So we don't have any problem with Hengan International Group's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Hengan International Group , and understanding them should be part of your investment process.

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.