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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Huabao Flavours & Fragrances Co., Ltd. (SZSE:300741) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Huabao Flavours & Fragrances Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Huabao Flavours & Fragrances had CN¥274.0m of debt, an increase on CN¥195.8m, over one year. But it also has CN¥4.85b in cash to offset that, meaning it has CN¥4.58b net cash.

How Strong Is Huabao Flavours & Fragrances' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Huabao Flavours & Fragrances had liabilities of CN¥540.7m due within 12 months and liabilities of CN¥209.6m due beyond that. On the other hand, it had cash of CN¥4.85b and CN¥498.4m worth of receivables due within a year. So it actually has CN¥4.60b more liquid assets than total liabilities.

This surplus strongly suggests that Huabao Flavours & Fragrances has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, Huabao Flavours & Fragrances boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Huabao Flavours & Fragrances if management cannot prevent a repeat of the 52% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Huabao Flavours & Fragrances will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Huabao Flavours & Fragrances may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, Huabao Flavours & Fragrances actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While it is always sensible to investigate a company's debt, in this case Huabao Flavours & Fragrances has CN¥4.58b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 120% of that EBIT to free cash flow, bringing in CN¥425m. So we don't think Huabao Flavours & Fragrances's use of debt is risky. 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 Huabao Flavours & Fragrances is showing 3 warning signs in our investment analysis , and 2 of those don't sit too well with us...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.