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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Humanwell Healthcare (Group) Co.,Ltd. (SHSE:600079) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Humanwell Healthcare (Group)Ltd's Debt?

The image below, which you can click on for greater detail, shows that Humanwell Healthcare (Group)Ltd had debt of CN¥9.47b at the end of September 2024, a reduction from CN¥10.1b over a year. However, because it has a cash reserve of CN¥4.76b, its net debt is less, at about CN¥4.71b.

How Strong Is Humanwell Healthcare (Group)Ltd's Balance Sheet?

We can see from the most recent balance sheet that Humanwell Healthcare (Group)Ltd had liabilities of CN¥13.7b falling due within a year, and liabilities of CN¥2.60b due beyond that. On the other hand, it had cash of CN¥4.76b and CN¥11.0b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥543.3m.

This state of affairs indicates that Humanwell Healthcare (Group)Ltd's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥35.2b company is short on cash, but still worth keeping an eye on the balance sheet.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Humanwell Healthcare (Group)Ltd has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 17.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Humanwell Healthcare (Group)Ltd has been able to increase its EBIT by 20% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Humanwell Healthcare (Group)Ltd's ability to maintain a healthy balance sheet going forward. 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Humanwell Healthcare (Group)Ltd created free cash flow amounting to 9.0% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

The good news is that Humanwell Healthcare (Group)Ltd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Humanwell Healthcare (Group)Ltd can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. Be aware that Humanwell Healthcare (Group)Ltd is showing 1 warning sign in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.