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. As with many other companies Huafon Chemical Co.,Ltd (SZSE:002064) makes use of 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Huafon ChemicalLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Huafon ChemicalLtd had debt of CN¥5.95b, up from CN¥4.85b in one year. But it also has CN¥11.3b in cash to offset that, meaning it has CN¥5.40b net cash.

A Look At Huafon ChemicalLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Huafon ChemicalLtd had liabilities of CN¥10.8b due within 12 months and liabilities of CN¥1.91b due beyond that. On the other hand, it had cash of CN¥11.3b and CN¥6.54b worth of receivables due within a year. So it can boast CN¥5.18b more liquid assets than total liabilities.

This surplus suggests that Huafon ChemicalLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Huafon ChemicalLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

Another good sign is that Huafon ChemicalLtd has been able to increase its EBIT by 27% in twelve months, making it easier to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Huafon ChemicalLtd'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Huafon ChemicalLtd 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. Looking at the most recent three years, Huafon ChemicalLtd recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While it is always sensible to investigate a company's debt, in this case Huafon ChemicalLtd has CN¥5.40b in net cash and a decent-looking balance sheet. And we liked the look of last year's 27% year-on-year EBIT growth. So we don't think Huafon ChemicalLtd's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Huafon ChemicalLtd that you should be aware of.

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.