David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that Henan Liliang Diamond Co., Ltd. (SZSE:301071) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Henan Liliang Diamond's Debt?

As you can see below, at the end of March 2024, Henan Liliang Diamond had CN¥409.8m of debt, up from CN¥266.8m a year ago. Click the image for more detail. But it also has CN¥3.77b in cash to offset that, meaning it has CN¥3.36b net cash.

A Look At Henan Liliang Diamond's Liabilities

Zooming in on the latest balance sheet data, we can see that Henan Liliang Diamond had liabilities of CN¥753.5m due within 12 months and liabilities of CN¥451.8m due beyond that. On the other hand, it had cash of CN¥3.77b and CN¥248.2m worth of receivables due within a year. So it actually has CN¥2.81b more liquid assets than total liabilities.

This luscious liquidity implies that Henan Liliang Diamond's balance sheet is sturdy like a giant sequoia tree. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Henan Liliang Diamond has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Henan Liliang Diamond's saving grace is its low debt levels, because its EBIT has tanked 24% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Henan Liliang Diamond'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Henan Liliang Diamond 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. During the last three years, Henan Liliang Diamond burned a lot of cash. 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 Henan Liliang Diamond has net cash of CN¥3.36b, as well as more liquid assets than liabilities. So we don't have any problem with Henan Liliang Diamond'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. We've identified 2 warning signs with Henan Liliang Diamond (at least 1 which is concerning) , 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.

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