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.' 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 Kinco Automation (Shanghai) Co.,Ltd (SHSE:688160) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 Kinco Automation (Shanghai)Ltd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Kinco Automation (Shanghai)Ltd had CN¥40.0m of debt, an increase on none, over one year. However, it does have CN¥343.7m in cash offsetting this, leading to net cash of CN¥303.7m.

How Strong Is Kinco Automation (Shanghai)Ltd's Balance Sheet?

We can see from the most recent balance sheet that Kinco Automation (Shanghai)Ltd had liabilities of CN¥143.5m falling due within a year, and liabilities of CN¥22.5m due beyond that. Offsetting this, it had CN¥343.7m in cash and CN¥151.2m in receivables that were due within 12 months. So it can boast CN¥329.0m more liquid assets than total liabilities.

This short term liquidity is a sign that Kinco Automation (Shanghai)Ltd could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Kinco Automation (Shanghai)Ltd has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Kinco Automation (Shanghai)Ltd's saving grace is its low debt levels, because its EBIT has tanked 46% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Kinco Automation (Shanghai)Ltd will need earnings to service that debt. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Kinco Automation (Shanghai)Ltd 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 most recent three years, Kinco Automation (Shanghai)Ltd recorded free cash flow worth 66% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Kinco Automation (Shanghai)Ltd has net cash of CN¥303.7m, as well as more liquid assets than liabilities. The cherry on top was that in converted 66% of that EBIT to free cash flow, bringing in CN¥36m. So we don't have any problem with Kinco Automation (Shanghai)Ltd's use of debt. 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 3 warning signs with Kinco Automation (Shanghai)Ltd (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

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.