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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Kunshan Huguang Auto Harness Co.,Ltd. (SHSE:605333) does carry debt. But should shareholders be worried about its use of debt?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Kunshan Huguang Auto HarnessLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Kunshan Huguang Auto HarnessLtd had debt of CN¥2.02b, up from CN¥1.83b in one year. However, it also had CN¥599.6m in cash, and so its net debt is CN¥1.42b.

How Healthy Is Kunshan Huguang Auto HarnessLtd's Balance Sheet?

We can see from the most recent balance sheet that Kunshan Huguang Auto HarnessLtd had liabilities of CN¥4.12b falling due within a year, and liabilities of CN¥826.6m due beyond that. Offsetting this, it had CN¥599.6m in cash and CN¥2.97b in receivables that were due within 12 months. So it has liabilities totalling CN¥1.38b more than its cash and near-term receivables, combined.

Given Kunshan Huguang Auto HarnessLtd has a market capitalization of CN¥14.5b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

We'd say that Kunshan Huguang Auto HarnessLtd's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its commanding EBIT of 11.2 times its interest expense, implies the debt load is as light as a peacock feather. Better yet, Kunshan Huguang Auto HarnessLtd grew its EBIT by 2,059% last year, which is an impressive improvement. That boost will make it even 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 Kunshan Huguang Auto HarnessLtd 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, Kunshan Huguang Auto HarnessLtd 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.

Our View

Based on what we've seen Kunshan Huguang Auto HarnessLtd is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its EBIT growth rate. When we consider all the elements mentioned above, it seems to us that Kunshan Huguang Auto HarnessLtd is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Be aware that Kunshan Huguang Auto HarnessLtd is showing 1 warning sign in our investment analysis , you should know about...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.