Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Hongfa Technology Co., Ltd. (SHSE:600885) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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 Hongfa Technology's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Hongfa Technology had CN¥3.91b of debt, an increase on CN¥2.91b, over one year. However, it also had CN¥3.72b in cash, and so its net debt is CN¥193.7m.

How Strong Is Hongfa Technology's Balance Sheet?

The latest balance sheet data shows that Hongfa Technology had liabilities of CN¥4.98b due within a year, and liabilities of CN¥3.41b falling due after that. Offsetting this, it had CN¥3.72b in cash and CN¥5.96b in receivables that were due within 12 months. So it actually has CN¥1.29b more liquid assets than total liabilities.

This surplus suggests that Hongfa Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Carrying virtually no net debt, Hongfa Technology has a very light debt load indeed.

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.

With debt at a measly 0.06 times EBITDA and EBIT covering interest a whopping 25.5 times, it's clear that Hongfa Technology is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. The good news is that Hongfa Technology has increased its EBIT by 9.1% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hongfa Technology 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Hongfa Technology's free cash flow amounted to 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Hongfa Technology's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. When we consider the range of factors above, it looks like Hongfa Technology is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. For example - Hongfa Technology has 1 warning sign we think you should be aware of.

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.