David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Hongrun Construction Group Co., Ltd. (SZSE:002062) makes use of debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Hongrun Construction Group's Net Debt?

The image below, which you can click on for greater detail, shows that Hongrun Construction Group had debt of CN¥2.51b at the end of March 2024, a reduction from CN¥2.97b over a year. But it also has CN¥2.75b in cash to offset that, meaning it has CN¥236.6m net cash.

How Healthy Is Hongrun Construction Group's Balance Sheet?

We can see from the most recent balance sheet that Hongrun Construction Group had liabilities of CN¥8.65b falling due within a year, and liabilities of CN¥1.33b due beyond that. Offsetting this, it had CN¥2.75b in cash and CN¥6.42b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥813.3m.

Of course, Hongrun Construction Group has a market capitalization of CN¥4.10b, 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. While it does have liabilities worth noting, Hongrun Construction Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact Hongrun Construction Group's saving grace is its low debt levels, because its EBIT has tanked 48% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hongrun Construction Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Hongrun Construction Group 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. Happily for any shareholders, Hongrun Construction Group actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While Hongrun Construction Group does have more liabilities than liquid assets, it also has net cash of CN¥236.6m. The cherry on top was that in converted 125% of that EBIT to free cash flow, bringing in CN¥323m. So we are not troubled with Hongrun Construction Group's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Hongrun Construction Group , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.