Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies MeiHua Holdings Group Co.,Ltd (SHSE:600873) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is MeiHua Holdings GroupLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that MeiHua Holdings GroupLtd had CN¥4.31b of debt in March 2024, down from CN¥5.08b, one year before. But it also has CN¥4.79b in cash to offset that, meaning it has CN¥479.6m net cash.

How Healthy Is MeiHua Holdings GroupLtd's Balance Sheet?

According to the last reported balance sheet, MeiHua Holdings GroupLtd had liabilities of CN¥6.44b due within 12 months, and liabilities of CN¥2.13b due beyond 12 months. Offsetting this, it had CN¥4.79b in cash and CN¥1.04b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.74b.

Given MeiHua Holdings GroupLtd has a market capitalization of CN¥31.7b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, MeiHua Holdings GroupLtd also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact MeiHua Holdings GroupLtd's saving grace is its low debt levels, because its EBIT has tanked 29% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 MeiHua Holdings GroupLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. MeiHua Holdings GroupLtd 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. Over the last three years, MeiHua Holdings GroupLtd recorded free cash flow worth a fulsome 96% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

We could understand if investors are concerned about MeiHua Holdings GroupLtd's liabilities, but we can be reassured by the fact it has has net cash of CN¥479.6m. The cherry on top was that in converted 96% of that EBIT to free cash flow, bringing in CN¥3.5b. So we are not troubled with MeiHua Holdings GroupLtd's debt use. 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. For example - MeiHua Holdings GroupLtd 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.