Is Huabao International Holdings (HKG:336) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Huabao International Holdings Limited (HKG:336) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Huabao International Holdings

How Much Debt Does Huabao International Holdings Carry?

As you can see below, Huabao International Holdings had CN¥677.7m of debt at December 2022, down from CN¥962.8m a year prior. But on the other hand it also has CN¥6.36b in cash, leading to a CN¥5.68b net cash position.

How Healthy Is Huabao International Holdings' Balance Sheet?

The latest balance sheet data shows that Huabao International Holdings had liabilities of CN¥1.75b due within a year, and liabilities of CN¥306.7m falling due after that. Offsetting this, it had CN¥6.36b in cash and CN¥1.04b in receivables that were due within 12 months. So it can boast CN¥5.33b 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. Having regard to this fact, we think its balance sheet is as strong as an ox. 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 38% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 we empathize with investors who find debt concerning, you should keep in mind that Huabao International Holdings has net cash of CN¥5.68b, as well as more liquid assets than liabilities. The cherry on top was that in converted 74% of that EBIT to free cash flow, bringing in CN¥364m. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Huabao International Holdings 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.