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 note that Huafu Fashion Co., Ltd. (SZSE:002042) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Huafu Fashion

How Much Debt Does Huafu Fashion Carry?

As you can see below, Huafu Fashion had CN¥7.99b of debt at September 2023, down from CN¥8.44b a year prior. However, because it has a cash reserve of CN¥3.91b, its net debt is less, at about CN¥4.08b.

How Strong Is Huafu Fashion's Balance Sheet?

The latest balance sheet data shows that Huafu Fashion had liabilities of CN¥8.82b due within a year, and liabilities of CN¥1.36b falling due after that. Offsetting this, it had CN¥3.91b in cash and CN¥1.38b in receivables that were due within 12 months. So its liabilities total CN¥4.89b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥5.82b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Huafu Fashion's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Over 12 months, Huafu Fashion made a loss at the EBIT level, and saw its revenue drop to CN¥12b, which is a fall of 29%. That makes us nervous, to say the least.

Caveat Emptor

Not only did Huafu Fashion's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at CN¥438m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. For example, we would not want to see a repeat of last year's loss of CN¥567m. In the meantime, we consider the stock very risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Huafu Fashion (of which 1 is significant!) you should know about.

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.