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. As with many other companies Hangzhou Honghua Digital Technology Stock Company LTD. (SHSE:688789) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

What Is Hangzhou Honghua Digital Technology Stock's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Hangzhou Honghua Digital Technology Stock had CN¥117.7m of debt, an increase on CN¥10.3m, over one year. But on the other hand it also has CN¥1.07b in cash, leading to a CN¥950.3m net cash position.

How Healthy Is Hangzhou Honghua Digital Technology Stock's Balance Sheet?

According to the last reported balance sheet, Hangzhou Honghua Digital Technology Stock had liabilities of CN¥546.6m due within 12 months, and liabilities of CN¥63.2m due beyond 12 months. On the other hand, it had cash of CN¥1.07b and CN¥576.4m worth of receivables due within a year. So it actually has CN¥1.03b more liquid assets than total liabilities.

This short term liquidity is a sign that Hangzhou Honghua Digital Technology Stock could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Hangzhou Honghua Digital Technology Stock has more cash than debt is arguably a good indication that it can manage its debt safely.

On top of that, Hangzhou Honghua Digital Technology Stock grew its EBIT by 53% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hangzhou Honghua Digital Technology Stock'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Hangzhou Honghua Digital Technology Stock 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. During the last three years, Hangzhou Honghua Digital Technology Stock burned a lot of cash. 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 Hangzhou Honghua Digital Technology Stock has CN¥950.3m in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 53% over the last year. So we are not troubled with Hangzhou Honghua Digital Technology Stock's debt use. 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. We've identified 1 warning sign with Hangzhou Honghua Digital Technology Stock , and understanding them should be part of your investment process.

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.