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.' 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 Anhui Huaren Health Pharmaceutical Co., Ltd. (SZSE:301408) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Anhui Huaren Health Pharmaceutical's Net Debt?

As you can see below, at the end of June 2024, Anhui Huaren Health Pharmaceutical had CN¥681.2m of debt, up from CN¥387.0m a year ago. Click the image for more detail. However, it does have CN¥1.02b in cash offsetting this, leading to net cash of CN¥334.4m.

How Healthy Is Anhui Huaren Health Pharmaceutical's Balance Sheet?

We can see from the most recent balance sheet that Anhui Huaren Health Pharmaceutical had liabilities of CN¥2.06b falling due within a year, and liabilities of CN¥630.1m due beyond that. Offsetting this, it had CN¥1.02b in cash and CN¥507.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.16b.

Anhui Huaren Health Pharmaceutical has a market capitalization of CN¥4.94b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Anhui Huaren Health Pharmaceutical boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Anhui Huaren Health Pharmaceutical's saving grace is its low debt levels, because its EBIT has tanked 25% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is Anhui Huaren Health Pharmaceutical's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Anhui Huaren Health Pharmaceutical 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. During the last three years, Anhui Huaren Health Pharmaceutical produced sturdy free cash flow equating to 54% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

Although Anhui Huaren Health Pharmaceutical's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥334.4m. So we don't have any problem with Anhui Huaren Health Pharmaceutical'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. Case in point: We've spotted 2 warning signs for Anhui Huaren Health Pharmaceutical you should be aware of.

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.