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 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. As with many other companies Hengan International Group Company Limited (HKG:1044) makes use of debt. But the real question is whether this debt is making the company risky.

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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is Hengan International Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Hengan International Group had CN¥14.2b of debt in December 2023, down from CN¥17.0b, one year before. But on the other hand it also has CN¥18.2b in cash, leading to a CN¥3.98b net cash position.

How Strong Is Hengan International Group's Balance Sheet?

We can see from the most recent balance sheet that Hengan International Group had liabilities of CN¥19.1b falling due within a year, and liabilities of CN¥525.8m due beyond that. Offsetting this, it had CN¥18.2b in cash and CN¥3.53b in receivables that were due within 12 months. So it can boast CN¥2.16b more liquid assets than total liabilities.

This short term liquidity is a sign that Hengan International Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Hengan International Group has more cash than debt is arguably a good indication that it can manage its debt safely.

Fortunately, Hengan International Group grew its EBIT by 5.9% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Hengan International Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Hengan International Group 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 last three years, Hengan International Group recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to investigate a company's debt, in this case Hengan International Group has CN¥3.98b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 83% of that EBIT to free cash flow, bringing in CN¥2.4b. So we don't think Hengan International Group's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - Hengan International Group has 1 warning sign we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.