Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Huafu Fashion Co., Ltd. (SZSE:002042) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Huafu Fashion Carry?

As you can see below, at the end of March 2024, Huafu Fashion had CN¥8.70b of debt, up from CN¥8.16b a year ago. Click the image for more detail. However, it does have CN¥2.81b in cash offsetting this, leading to net debt of about CN¥5.90b.

A Look At Huafu Fashion's Liabilities

According to the last reported balance sheet, Huafu Fashion had liabilities of CN¥10.2b due within 12 months, and liabilities of CN¥1.13b due beyond 12 months. Offsetting this, it had CN¥2.81b in cash and CN¥1.60b in receivables that were due within 12 months. So it has liabilities totalling CN¥6.93b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥6.81b, we think shareholders really should watch Huafu Fashion's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Huafu Fashion'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.

In the last year Huafu Fashion had a loss before interest and tax, and actually shrunk its revenue by 12%, to CN¥13b. We would much prefer see growth.

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¥64m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it had negative free cash flow of CN¥447m over the last twelve months. So suffice it to say we consider the stock to be 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Huafu Fashion (of which 1 is concerning!) you should know about.

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.