Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Hunan Aihua Group Co., Ltd (SHSE:603989) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

See our latest analysis for Hunan Aihua Group

What Is Hunan Aihua Group's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Hunan Aihua Group had debt of CN¥688.4m, up from CN¥574.9m in one year. But on the other hand it also has CN¥1.37b in cash, leading to a CN¥678.5m net cash position.

How Strong Is Hunan Aihua Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hunan Aihua Group had liabilities of CN¥1.47b due within 12 months and liabilities of CN¥523.2m due beyond that. Offsetting this, it had CN¥1.37b in cash and CN¥1.50b in receivables that were due within 12 months. So it actually has CN¥871.4m more liquid assets than total liabilities.

This surplus suggests that Hunan Aihua Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Hunan Aihua Group boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Hunan Aihua Group saw its EBIT drop by 5.4% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hunan Aihua Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Hunan Aihua Group 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. In the last three years, Hunan Aihua Group created free cash flow amounting to 7.0% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Hunan Aihua Group has net cash of CN¥678.5m, as well as more liquid assets than liabilities. So we are not troubled with Hunan Aihua Group's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Hunan Aihua Group that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.