Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies AVIC Heavy Machinery Co., Ltd. (SHSE:600765) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does AVIC Heavy Machinery Carry?

The image below, which you can click on for greater detail, shows that at March 2024 AVIC Heavy Machinery had debt of CN¥3.26b, up from CN¥2.74b in one year. However, it does have CN¥4.80b in cash offsetting this, leading to net cash of CN¥1.54b.

How Healthy Is AVIC Heavy Machinery's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that AVIC Heavy Machinery had liabilities of CN¥10.6b due within 12 months and liabilities of CN¥2.54b due beyond that. Offsetting this, it had CN¥4.80b in cash and CN¥9.76b in receivables that were due within 12 months. So it can boast CN¥1.46b more liquid assets than total liabilities.

This short term liquidity is a sign that AVIC Heavy Machinery could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, AVIC Heavy Machinery boasts net cash, so it's fair to say it does not have a heavy debt load!

The good news is that AVIC Heavy Machinery has increased its EBIT by 4.7% over twelve months, which should ease any concerns about debt repayment. 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 AVIC Heavy Machinery's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. AVIC Heavy Machinery 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. Considering the last three years, AVIC Heavy Machinery actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that AVIC Heavy Machinery has net cash of CN¥1.54b, as well as more liquid assets than liabilities. And it also grew its EBIT by 4.7% over the last year. So we don't have any problem with AVIC Heavy Machinery's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 1 warning sign for AVIC Heavy Machinery you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com