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

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.' 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 Huabao International Holdings Limited (HKG:336) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Huabao International Holdings

What Is Huabao International Holdings's Net Debt?

As you can see below, Huabao International Holdings had CN¥219.0m of debt at June 2024, down from CN¥466.9m a year prior. However, its balance sheet shows it holds CN¥6.01b in cash, so it actually has CN¥5.79b net cash.

How Strong Is Huabao International Holdings' Balance Sheet?

The latest balance sheet data shows that Huabao International Holdings had liabilities of CN¥934.2m due within a year, and liabilities of CN¥333.8m falling due after that. Offsetting this, it had CN¥6.01b in cash and CN¥666.3m in receivables that were due within 12 months. So it actually has CN¥5.41b more liquid assets than total liabilities.

This luscious liquidity implies that Huabao International Holdings' balance sheet is sturdy like a giant sequoia tree. 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.

In fact Huabao International Holdings's saving grace is its low debt levels, because its EBIT has tanked 58% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Huabao International 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Huabao International Holdings 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, Huabao International Holdings produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to investigate a company's debt, in this case Huabao International Holdings has CN¥5.79b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥346m, being 74% 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. We've identified 3 warning signs with Huabao International Holdings (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.