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 Guangzhou Haozhi Industrial Co.,Ltd. (SZSE:300503) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Guangzhou Haozhi IndustrialLtd Carry?

The chart below, which you can click on for greater detail, shows that Guangzhou Haozhi IndustrialLtd had CN¥630.7m in debt in June 2024; about the same as the year before. On the flip side, it has CN¥73.9m in cash leading to net debt of about CN¥556.8m.

How Healthy Is Guangzhou Haozhi IndustrialLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Guangzhou Haozhi IndustrialLtd had liabilities of CN¥930.0m due within 12 months and liabilities of CN¥535.1m due beyond that. Offsetting these obligations, it had cash of CN¥73.9m as well as receivables valued at CN¥690.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥700.2m.

Since publicly traded Guangzhou Haozhi IndustrialLtd shares are worth a total of CN¥4.62b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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).

Weak interest cover of 0.28 times and a disturbingly high net debt to EBITDA ratio of 5.3 hit our confidence in Guangzhou Haozhi IndustrialLtd like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for Guangzhou Haozhi IndustrialLtd is that it turned last year's EBIT loss into a gain of CN¥10m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Guangzhou Haozhi IndustrialLtd 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 company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Guangzhou Haozhi IndustrialLtd 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

To be frank both Guangzhou Haozhi IndustrialLtd's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. Overall, we think it's fair to say that Guangzhou Haozhi IndustrialLtd has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For example - Guangzhou Haozhi IndustrialLtd has 2 warning signs we think you should be aware of.

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.