Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Huafu Fashion Co., Ltd. (SZSE:002042) does use debt in its business. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Huafu Fashion

What Is Huafu Fashion's Net Debt?

The chart below, which you can click on for greater detail, shows that Huafu Fashion had CN¥8.59b in debt in June 2023; about the same as the year before. However, because it has a cash reserve of CN¥4.43b, its net debt is less, at about CN¥4.16b.

How Strong Is Huafu Fashion's Balance Sheet?

According to the last reported balance sheet, Huafu Fashion had liabilities of CN¥9.89b due within 12 months, and liabilities of CN¥1.40b due beyond 12 months. Offsetting these obligations, it had cash of CN¥4.43b as well as receivables valued at CN¥1.77b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.09b.

This is a mountain of leverage relative to its market capitalization of CN¥5.69b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Huafu Fashion 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.

In the last year Huafu Fashion had a loss before interest and tax, and actually shrunk its revenue by 18%, to CN¥14b. That's not what we would hope to see.

Caveat Emptor

Not only did Huafu Fashion's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost CN¥526m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. We would feel better if it turned its trailing twelve month loss of CN¥562m into a profit. So in short it's a really risky stock. 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 Huafu Fashion has 2 warning signs (and 1 which is potentially serious) we think 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.