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. As with many other companies Henan Liliang Diamond Co., Ltd. (SZSE:301071) makes use of debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Henan Liliang Diamond Carry?

As you can see below, at the end of June 2024, Henan Liliang Diamond had CN¥611.6m of debt, up from CN¥214.8m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥3.94b in cash, so it actually has CN¥3.33b net cash.

How Strong Is Henan Liliang Diamond's Balance Sheet?

The latest balance sheet data shows that Henan Liliang Diamond had liabilities of CN¥1.13b due within a year, and liabilities of CN¥343.5m falling due after that. Offsetting these obligations, it had cash of CN¥3.94b as well as receivables valued at CN¥313.7m due within 12 months. So it actually has CN¥2.78b more liquid assets than total liabilities.

This surplus strongly suggests that Henan Liliang Diamond has a rock-solid balance sheet (and the debt is of no concern whatsoever). Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that Henan Liliang Diamond has more cash than debt is arguably a good indication that it can manage its debt safely.

But the bad news is that Henan Liliang Diamond has seen its EBIT plunge 16% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Henan Liliang Diamond 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Henan Liliang Diamond 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. During the last three years, Henan Liliang Diamond burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Henan Liliang Diamond has net cash of CN¥3.33b, as well as more liquid assets than liabilities. So we are not troubled with Henan Liliang Diamond's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Henan Liliang Diamond (of which 1 makes us a bit uncomfortable!) you should know about.

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.

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