Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Shandong Longhua New Material Co., Ltd. (SZSE:301149) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Shandong Longhua New Material Carry?

As you can see below, at the end of March 2024, Shandong Longhua New Material had CN¥707.7m of debt, up from CN¥2.42m a year ago. Click the image for more detail. But it also has CN¥1.02b in cash to offset that, meaning it has CN¥311.1m net cash.

How Healthy Is Shandong Longhua New Material's Balance Sheet?

The latest balance sheet data shows that Shandong Longhua New Material had liabilities of CN¥468.9m due within a year, and liabilities of CN¥697.1m falling due after that. Offsetting these obligations, it had cash of CN¥1.02b as well as receivables valued at CN¥268.2m due within 12 months. So it can boast CN¥121.0m more liquid assets than total liabilities.

This surplus suggests that Shandong Longhua New Material has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Shandong Longhua New Material has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Shandong Longhua New Material grew its EBIT by 105% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shandong Longhua New Material 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Shandong Longhua New Material 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. During the last three years, Shandong Longhua New Material burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shandong Longhua New Material has CN¥311.1m in net cash and a decent-looking balance sheet. And we liked the look of last year's 105% year-on-year EBIT growth. So we are not troubled with Shandong Longhua New Material'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. We've identified 2 warning signs with Shandong Longhua New Material (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.