The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Huafon Microfibre (Shanghai) Co., Ltd. (SZSE:300180) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Huafon Microfibre (Shanghai)'s Net Debt?

As you can see below, Huafon Microfibre (Shanghai) had CN¥1.58b of debt at September 2023, down from CN¥1.82b a year prior. However, because it has a cash reserve of CN¥372.0m, its net debt is less, at about CN¥1.21b.

A Look At Huafon Microfibre (Shanghai)'s Liabilities

The latest balance sheet data shows that Huafon Microfibre (Shanghai) had liabilities of CN¥2.41b due within a year, and liabilities of CN¥777.4m falling due after that. On the other hand, it had cash of CN¥372.0m and CN¥1.31b worth of receivables due within a year. So it has liabilities totalling CN¥1.51b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Huafon Microfibre (Shanghai) is worth CN¥5.76b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Huafon Microfibre (Shanghai) will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Over 12 months, Huafon Microfibre (Shanghai) made a loss at the EBIT level, and saw its revenue drop to CN¥4.2b, which is a fall of 2.4%. We would much prefer see growth.

Caveat Emptor

Importantly, Huafon Microfibre (Shanghai) had an earnings before interest and tax (EBIT) loss over the last year. To be specific the EBIT loss came in at CN¥52m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled CN¥13m in negative free cash flow over the last twelve months. So to be blunt we think it is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Huafon Microfibre (Shanghai) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.