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. We can see that Yi Hua Holdings Limited (HKG:2213) does use debt in its business. But the real question is whether this debt is making the company risky.

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. 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. 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.

Check out our latest analysis for Yi Hua Holdings

What Is Yi Hua Holdings's Net Debt?

As you can see below, at the end of June 2019, Yi Hua Holdings had CN¥636.3m of debt, up from CN¥502.7m a year ago. Click the image for more detail. However, it also had CN¥91.4m in cash, and so its net debt is CN¥544.9m.

How Strong Is Yi Hua Holdings's Balance Sheet?

We can see from the most recent balance sheet that Yi Hua Holdings had liabilities of CN¥1.75b falling due within a year, and liabilities of CN¥839.2m due beyond that. On the other hand, it had cash of CN¥91.4m and CN¥302.8m worth of receivables due within a year. So it has liabilities totalling CN¥2.20b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥273.6m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we'd watch its balance sheet closely, without a doubt At the end of the day, Yi Hua Holdings would probably need a major re-capitalization if its creditors were to demand repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Yi Hua Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

In the last year Yi Hua Holdings had negative earnings before interest and tax, and actually shrunk its revenue by 44%, to CN¥513m. That makes us nervous, to say the least.

Caveat Emptor

While Yi Hua Holdings's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable CN¥76m at the EBIT level. When you combine this with the very significant balance sheet liabilities mentioned above, we are so wary of it that we are basically at a loss for the right words. Sure, the company might have a nice story about how they are going on to a brighter future. But the fact is that it incinerated CN¥48m of cash in the last twelve months, and has precious few liquid assets in comparison to its liabilities. So we consider this a high risk stock, and we're worried its share price could sink faster than than a dingy with a great white shark attacking it. When I consider a company to be a bit risky, I think it is responsible to check out whether insiders have been reporting any share sales. Luckily, you can click here ito see our graphic depicting Yi Hua Holdings insider transactions.

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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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.