The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 can see that Hangzhou Century Co., Ltd (SZSE:300078) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Hangzhou Century's Net Debt?

The image below, which you can click on for greater detail, shows that Hangzhou Century had debt of CN¥1.09b at the end of June 2024, a reduction from CN¥1.70b over a year. However, it also had CN¥821.1m in cash, and so its net debt is CN¥268.3m.

How Strong Is Hangzhou Century's Balance Sheet?

We can see from the most recent balance sheet that Hangzhou Century had liabilities of CN¥1.57b falling due within a year, and liabilities of CN¥736.6m due beyond that. On the other hand, it had cash of CN¥821.1m and CN¥630.3m worth of receivables due within a year. So its liabilities total CN¥854.8m more than the combination of its cash and short-term receivables.

Hangzhou Century has a market capitalization of CN¥3.63b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. 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 Hangzhou Century will need earnings to service that debt. 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.

In the last year Hangzhou Century had a loss before interest and tax, and actually shrunk its revenue by 14%, to CN¥840m. We would much prefer see growth.

Caveat Emptor

While Hangzhou Century's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Its EBIT loss was a whopping CN¥409m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. We would feel better if it turned its trailing twelve month loss of CN¥999m into a profit. So to be blunt we do think it is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Hangzhou Century is showing 3 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.