Huabao International Holdings (HKG:336) Could Easily Take On More Debt

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.' 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. As with many other companies Huabao International Holdings Limited (HKG:336) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out the opportunities and risks within the HK Chemicals industry.

How Much Debt Does Huabao International Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that Huabao International Holdings had CN¥507.0m of debt in June 2022, down from CN¥1.86b, one year before. However, it does have CN¥5.96b in cash offsetting this, leading to net cash of CN¥5.46b.

How Healthy Is Huabao International Holdings' Balance Sheet?

We can see from the most recent balance sheet that Huabao International Holdings had liabilities of CN¥1.43b falling due within a year, and liabilities of CN¥290.1m due beyond that. On the other hand, it had cash of CN¥5.96b and CN¥1.03b worth of receivables due within a year. So it can boast CN¥5.28b more liquid assets than total liabilities.

This excess liquidity is a great indication that Huabao International Holdings' balance sheet is almost as strong as Fort Knox. With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that Huabao International Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Huabao International Holdings if management cannot prevent a repeat of the 22% cut to EBIT over the last year. 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 it is Huabao International Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Huabao International 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. Over the last three years, Huabao International Holdings recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually 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 Huabao International Holdings has CN¥5.46b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥611m, being 81% of its EBIT. So is Huabao International 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. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Huabao International Holdings (1 makes us a bit uncomfortable) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.