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.' 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. As with many other companies Health and Happiness (H&H) International Holdings Limited (HKG:1112) 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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Health and Happiness (H&H) International Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that Health and Happiness (H&H) International Holdings had CN¥9.50b of debt in June 2024, down from CN¥10.1b, one year before. On the flip side, it has CN¥2.43b in cash leading to net debt of about CN¥7.07b.

How Healthy Is Health and Happiness (H&H) International Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Health and Happiness (H&H) International Holdings had liabilities of CN¥9.21b due within 12 months and liabilities of CN¥4.66b due beyond that. On the other hand, it had cash of CN¥2.43b and CN¥1.16b worth of receivables due within a year. So its liabilities total CN¥10.3b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥4.59b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Health and Happiness (H&H) International Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Health and Happiness (H&H) International Holdings's debt to EBITDA ratio (3.9) suggests that it uses some debt, its interest cover is very weak, at 1.9, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Another concern for investors might be that Health and Happiness (H&H) International Holdings's EBIT fell 11% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. 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 Health and Happiness (H&H) International Holdings 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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Health and Happiness (H&H) International Holdings actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

To be frank both Health and Happiness (H&H) International Holdings's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Health and Happiness (H&H) International Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Health and Happiness (H&H) International Holdings is showing 4 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

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.