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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Shanghai Huafon Aluminium Corporation (SHSE:601702) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Shanghai Huafon Aluminium's Debt?

As you can see below, Shanghai Huafon Aluminium had CN¥1.85b of debt at September 2023, down from CN¥2.09b a year prior. However, it does have CN¥230.9m in cash offsetting this, leading to net debt of about CN¥1.62b.

How Strong Is Shanghai Huafon Aluminium's Balance Sheet?

The latest balance sheet data shows that Shanghai Huafon Aluminium had liabilities of CN¥2.39b due within a year, and liabilities of CN¥205.0m falling due after that. On the other hand, it had cash of CN¥230.9m and CN¥2.53b worth of receivables due within a year. So it can boast CN¥159.9m more liquid assets than total liabilities.

Having regard to Shanghai Huafon Aluminium's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥18.4b company is struggling for cash, we still think it's worth monitoring its balance sheet.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shanghai Huafon Aluminium has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 16.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Shanghai Huafon Aluminium has been able to increase its EBIT by 23% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shanghai Huafon Aluminium can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Shanghai Huafon Aluminium created free cash flow amounting to 12% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Shanghai Huafon Aluminium's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that Shanghai Huafon Aluminium takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Shanghai Huafon Aluminium's earnings per share history for free.

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.