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.' 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. Importantly, Ningbo Huaxiang Electronic Co., Ltd. (SZSE:002048) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Ningbo Huaxiang Electronic's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Ningbo Huaxiang Electronic had debt of CN¥1.49b, up from CN¥746.2m in one year. But it also has CN¥3.01b in cash to offset that, meaning it has CN¥1.53b net cash.

How Healthy Is Ningbo Huaxiang Electronic's Balance Sheet?

The latest balance sheet data shows that Ningbo Huaxiang Electronic had liabilities of CN¥10.3b due within a year, and liabilities of CN¥1.87b falling due after that. Offsetting these obligations, it had cash of CN¥3.01b as well as receivables valued at CN¥7.45b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.69b.

Of course, Ningbo Huaxiang Electronic has a market capitalization of CN¥10.6b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Ningbo Huaxiang Electronic also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that Ningbo Huaxiang Electronic has boosted its EBIT by 30%, thus reducing the spectre of future debt repayments. 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 Ningbo Huaxiang Electronic'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Ningbo Huaxiang Electronic 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. During the last three years, Ningbo Huaxiang Electronic produced sturdy free cash flow equating to 58% 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 Ningbo Huaxiang Electronic does have more liabilities than liquid assets, it also has net cash of CN¥1.53b. And it impressed us with its EBIT growth of 30% over the last year. So we don't think Ningbo Huaxiang Electronic's use of debt is risky. 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. We've identified 1 warning sign with Ningbo Huaxiang Electronic , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.