Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Dongguan Huali Industries Co.,Ltd (SHSE:603038) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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. 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 Dongguan Huali IndustriesLtd Carry?

The image below, which you can click on for greater detail, shows that Dongguan Huali IndustriesLtd had debt of CN¥303.1m at the end of September 2024, a reduction from CN¥469.5m over a year. On the flip side, it has CN¥238.4m in cash leading to net debt of about CN¥64.7m.

How Strong Is Dongguan Huali IndustriesLtd's Balance Sheet?

We can see from the most recent balance sheet that Dongguan Huali IndustriesLtd had liabilities of CN¥180.1m falling due within a year, and liabilities of CN¥315.1m due beyond that. On the other hand, it had cash of CN¥238.4m and CN¥137.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥119.7m.

Since publicly traded Dongguan Huali IndustriesLtd shares are worth a total of CN¥4.52b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Dongguan Huali IndustriesLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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.

Dongguan Huali IndustriesLtd has a very low debt to EBITDA ratio of 0.70 so it is strange to see weak interest coverage, with last year's EBIT being only 2.1 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Shareholders should be aware that Dongguan Huali IndustriesLtd's EBIT was down 24% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is Dongguan Huali IndustriesLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Dongguan Huali IndustriesLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Dongguan Huali IndustriesLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Dongguan Huali IndustriesLtd stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. We've identified 3 warning signs with Dongguan Huali IndustriesLtd (at least 2 which are concerning) , 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.