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 Huadian Heavy Industries Co., Ltd. (SHSE:601226) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Huadian Heavy Industries's Debt?

The image below, which you can click on for greater detail, shows that Huadian Heavy Industries had debt of CN¥25.0m at the end of March 2024, a reduction from CN¥299.5m over a year. However, its balance sheet shows it holds CN¥1.39b in cash, so it actually has CN¥1.37b net cash.

How Healthy Is Huadian Heavy Industries' Balance Sheet?

We can see from the most recent balance sheet that Huadian Heavy Industries had liabilities of CN¥6.06b falling due within a year, and liabilities of CN¥35.1m due beyond that. Offsetting this, it had CN¥1.39b in cash and CN¥4.44b in receivables that were due within 12 months. So its liabilities total CN¥257.3m more than the combination of its cash and short-term receivables.

Given Huadian Heavy Industries has a market capitalization of CN¥5.72b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Huadian Heavy Industries also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Huadian Heavy Industries if management cannot prevent a repeat of the 74% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Huadian Heavy Industries can strengthen its balance sheet over time. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Huadian Heavy Industries 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 most recent three years, Huadian Heavy Industries recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

We could understand if investors are concerned about Huadian Heavy Industries's liabilities, but we can be reassured by the fact it has has net cash of CN¥1.37b. And it impressed us with free cash flow of CN¥27m, being 77% of its EBIT. So we don't have any problem with Huadian Heavy Industries's use of debt. 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 example, we've discovered 2 warning signs for Huadian Heavy Industries that you should be aware of before investing here.

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