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.' 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. Importantly, HUAYU Automotive Systems Company Limited (SHSE:600741) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does HUAYU Automotive Systems Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 HUAYU Automotive Systems had CN¥16.7b of debt, an increase on CN¥14.5b, over one year. But it also has CN¥41.5b in cash to offset that, meaning it has CN¥24.7b net cash.

How Strong Is HUAYU Automotive Systems' Balance Sheet?

We can see from the most recent balance sheet that HUAYU Automotive Systems had liabilities of CN¥101.6b falling due within a year, and liabilities of CN¥9.98b due beyond that. On the other hand, it had cash of CN¥41.5b and CN¥48.8b worth of receivables due within a year. So its liabilities total CN¥21.3b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since HUAYU Automotive Systems has a market capitalization of CN¥50.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, HUAYU Automotive Systems boasts net cash, so it's fair to say it does not have a heavy debt load!

The good news is that HUAYU Automotive Systems has increased its EBIT by 2.4% over twelve months, which should ease any concerns about debt repayment. 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 HUAYU Automotive Systems's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. HUAYU Automotive Systems 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. Over the last three years, HUAYU Automotive Systems recorded free cash flow worth a fulsome 81% 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 HUAYU Automotive Systems does have more liabilities than liquid assets, it also has net cash of CN¥24.7b. And it impressed us with free cash flow of CN¥7.1b, being 81% of its EBIT. So we don't have any problem with HUAYU Automotive Systems's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with HUAYU Automotive Systems (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com