Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Hunan Aihua Group Co., Ltd (SHSE:603989) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. 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 Hunan Aihua Group Carry?

You can click the graphic below for the historical numbers, but it shows that Hunan Aihua Group had CN¥324.0m of debt in June 2024, down from CN¥684.8m, one year before. However, it does have CN¥1.05b in cash offsetting this, leading to net cash of CN¥725.1m.

How Strong Is Hunan Aihua Group's Balance Sheet?

We can see from the most recent balance sheet that Hunan Aihua Group had liabilities of CN¥1.87b falling due within a year, and liabilities of CN¥122.3m due beyond that. Offsetting this, it had CN¥1.05b in cash and CN¥1.80b in receivables that were due within 12 months. So it actually has CN¥860.2m more liquid assets than total liabilities.

This excess liquidity suggests that Hunan Aihua Group is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Hunan Aihua Group has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Hunan Aihua Group's load is not too heavy, because its EBIT was down 31% over the last year. 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 ultimately the future profitability of the business will decide if Hunan Aihua Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Hunan Aihua Group 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. In the last three years, Hunan Aihua Group created free cash flow amounting to 2.1% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Hunan Aihua Group has CN¥725.1m in net cash and a decent-looking balance sheet. So we are not troubled with Hunan Aihua Group's debt use. 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. We've identified 2 warning signs with Hunan Aihua Group , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.