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. We note that Hunan Aihua Group Co., Ltd (SHSE:603989) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Hunan Aihua Group's Debt?

The image below, which you can click on for greater detail, shows that Hunan Aihua Group had debt of CN¥335.0m at the end of March 2024, a reduction from CN¥819.2m over a year. But it also has CN¥1.14b in cash to offset that, meaning it has CN¥800.6m net cash.

A Look At Hunan Aihua Group's Liabilities

Zooming in on the latest balance sheet data, we can see that Hunan Aihua Group had liabilities of CN¥1.76b due within 12 months and liabilities of CN¥125.4m due beyond that. Offsetting these obligations, it had cash of CN¥1.14b as well as receivables valued at CN¥1.56b due within 12 months. So it actually has CN¥814.5m more liquid assets than total liabilities.

It's good to see that Hunan Aihua Group has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, Hunan Aihua Group boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Hunan Aihua Group's load is not too heavy, because its EBIT was down 30% over the last year. 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 it is future earnings, more than anything, that will determine Hunan Aihua Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Hunan Aihua 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. Over the last three years, Hunan Aihua Group reported free cash flow worth 2.9% of its EBIT, which is really quite low. 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¥800.6m, as well as more liquid assets than liabilities. So we don't have any problem with Hunan Aihua Group's use of debt. 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. Be aware that Hunan Aihua Group is showing 2 warning signs in our investment analysis , you should know about...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com