Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Guangdong Hoshion Industrial Aluminium Co., Ltd. (SZSE:002824) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Guangdong Hoshion Industrial Aluminium's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Guangdong Hoshion Industrial Aluminium had CN¥1.09b of debt, an increase on CN¥420.8m, over one year. However, it also had CN¥399.6m in cash, and so its net debt is CN¥686.5m.

A Look At Guangdong Hoshion Industrial Aluminium's Liabilities

Zooming in on the latest balance sheet data, we can see that Guangdong Hoshion Industrial Aluminium had liabilities of CN¥1.51b due within 12 months and liabilities of CN¥586.2m due beyond that. Offsetting this, it had CN¥399.6m in cash and CN¥1.47b in receivables that were due within 12 months. So its liabilities total CN¥231.2m more than the combination of its cash and short-term receivables.

Of course, Guangdong Hoshion Industrial Aluminium has a market capitalization of CN¥3.77b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Guangdong Hoshion Industrial Aluminium has net debt to EBITDA of 2.8 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.8 suggests it can easily service that debt. Importantly, Guangdong Hoshion Industrial Aluminium's EBIT fell a jaw-dropping 29% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Guangdong Hoshion Industrial Aluminium 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Guangdong Hoshion Industrial Aluminium 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.

Our View

On the face of it, Guangdong Hoshion Industrial Aluminium's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Guangdong Hoshion Industrial Aluminium stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 3 warning signs with Guangdong Hoshion Industrial Aluminium (at least 1 which is significant) , and understanding them should be part of your investment process.

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.