Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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, Hangzhou First Applied Material Co., Ltd. (SHSE:603806) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Hangzhou First Applied Material's Debt?

As you can see below, at the end of March 2024, Hangzhou First Applied Material had CN¥4.36b of debt, up from CN¥4.14b a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥5.38b in cash, so it actually has CN¥1.02b net cash.

A Look At Hangzhou First Applied Material's Liabilities

According to the last reported balance sheet, Hangzhou First Applied Material had liabilities of CN¥3.43b due within 12 months, and liabilities of CN¥2.92b due beyond 12 months. On the other hand, it had cash of CN¥5.38b and CN¥8.98b worth of receivables due within a year. So it actually has CN¥8.01b more liquid assets than total liabilities.

This excess liquidity suggests that Hangzhou First Applied Material is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Hangzhou First Applied Material has more cash than debt is arguably a good indication that it can manage its debt safely.

Also positive, Hangzhou First Applied Material grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hangzhou First Applied Material 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Hangzhou First Applied Material 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. Over the last three years, Hangzhou First Applied Material saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Hangzhou First Applied Material has net cash of CN¥1.02b, as well as more liquid assets than liabilities. And we liked the look of last year's 22% year-on-year EBIT growth. So we are not troubled with Hangzhou First Applied Material's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Hangzhou First Applied Material is showing 1 warning sign in our investment analysis , 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