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.' 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, Zhejiang Huamei Holding CO., LTD. (SZSE:000607) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Zhejiang Huamei Holding

What Is Zhejiang Huamei Holding's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Zhejiang Huamei Holding had debt of CN¥999.6m, up from CN¥594.5m in one year. On the flip side, it has CN¥994.3m in cash leading to net debt of about CN¥5.28m.

How Healthy Is Zhejiang Huamei Holding's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhejiang Huamei Holding had liabilities of CN¥1.80b due within 12 months and liabilities of CN¥332.1m due beyond that. Offsetting this, it had CN¥994.3m in cash and CN¥483.2m in receivables that were due within 12 months. So its liabilities total CN¥654.4m more than the combination of its cash and short-term receivables.

Of course, Zhejiang Huamei Holding has a market capitalization of CN¥4.57b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Carrying virtually no net debt, Zhejiang Huamei Holding has a very light debt load indeed. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Zhejiang Huamei Holding 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.

In the last year Zhejiang Huamei Holding's revenue was pretty flat, and it made a negative EBIT. While that hardly impresses, its not too bad either.

Caveat Emptor

Importantly, Zhejiang Huamei Holding had an earnings before interest and tax (EBIT) loss over the last year. To be specific the EBIT loss came in at CN¥21m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Surprisingly, we note that it actually reported positive free cash flow of CN¥362m and a profit of CN¥78m. So one might argue that there's still a chance it can get things on the right track. 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. We've identified 1 warning sign with Zhejiang Huamei Holding , 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.