Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that Jiangsu HHCK Advanced Materials Co.,Ltd (SHSE:688535) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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. 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.

What Is Jiangsu HHCK Advanced MaterialsLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Jiangsu HHCK Advanced MaterialsLtd had CN¥45.0m of debt, an increase on none, over one year. However, it does have CN¥30.2m in cash offsetting this, leading to net debt of about CN¥14.8m.

How Healthy Is Jiangsu HHCK Advanced MaterialsLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Jiangsu HHCK Advanced MaterialsLtd had liabilities of CN¥139.7m due within 12 months and liabilities of CN¥30.9m due beyond that. Offsetting this, it had CN¥30.2m in cash and CN¥169.7m in receivables that were due within 12 months. So it can boast CN¥29.3m more liquid assets than total liabilities.

Having regard to Jiangsu HHCK Advanced MaterialsLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥6.07b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Jiangsu HHCK Advanced MaterialsLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Jiangsu HHCK Advanced MaterialsLtd has net debt of just 0.46 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. It is just as well that Jiangsu HHCK Advanced MaterialsLtd's load is not too heavy, because its EBIT was down 40% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Jiangsu HHCK Advanced MaterialsLtd 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Jiangsu HHCK Advanced MaterialsLtd 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.

Our View

We feel some trepidation about Jiangsu HHCK Advanced MaterialsLtd's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that Jiangsu HHCK Advanced MaterialsLtd's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Jiangsu HHCK Advanced MaterialsLtd that you should be aware of.

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.