Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Huachangda Intelligent Equipment Group Co.,Ltd. (SZSE:300278) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Huachangda Intelligent Equipment GroupLtd's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Huachangda Intelligent Equipment GroupLtd had debt of CN¥57.3m, up from CN¥11.3m in one year. But on the other hand it also has CN¥555.8m in cash, leading to a CN¥498.5m net cash position.

How Healthy Is Huachangda Intelligent Equipment GroupLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Huachangda Intelligent Equipment GroupLtd had liabilities of CN¥1.23b due within 12 months and liabilities of CN¥44.8m due beyond that. Offsetting this, it had CN¥555.8m in cash and CN¥1.04b in receivables that were due within 12 months. So it can boast CN¥321.2m more liquid assets than total liabilities.

This surplus suggests that Huachangda Intelligent Equipment GroupLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Huachangda Intelligent Equipment GroupLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Huachangda Intelligent Equipment GroupLtd's saving grace is its low debt levels, because its EBIT has tanked 34% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is Huachangda Intelligent Equipment GroupLtd's earnings that will influence how the balance sheet holds up in the future. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Huachangda Intelligent Equipment GroupLtd 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 two years, Huachangda Intelligent Equipment GroupLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While it is always sensible to investigate a company's debt, in this case Huachangda Intelligent Equipment GroupLtd has CN¥498.5m in net cash and a decent-looking balance sheet. So although we see some areas for improvement, we're not too worried about Huachangda Intelligent Equipment GroupLtd's balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Huachangda Intelligent Equipment GroupLtd you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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