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.' 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, Shanghai Hugong Electric Group Co.,Ltd. (SHSE:603131) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Shanghai Hugong Electric GroupLtd Carry?

You can click the graphic below for the historical numbers, but it shows that Shanghai Hugong Electric GroupLtd had CN¥426.6m of debt in March 2024, down from CN¥545.2m, one year before. But on the other hand it also has CN¥806.6m in cash, leading to a CN¥380.0m net cash position.

A Look At Shanghai Hugong Electric GroupLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Shanghai Hugong Electric GroupLtd had liabilities of CN¥443.4m due within 12 months and liabilities of CN¥447.2m due beyond that. On the other hand, it had cash of CN¥806.6m and CN¥450.6m worth of receivables due within a year. So it can boast CN¥366.7m more liquid assets than total liabilities.

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

Even more impressive was the fact that Shanghai Hugong Electric GroupLtd grew its EBIT by 136% 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 it is Shanghai Hugong Electric GroupLtd'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Shanghai Hugong Electric GroupLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Shanghai Hugong Electric GroupLtd recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shanghai Hugong Electric GroupLtd has CN¥380.0m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥103m, being 94% of its EBIT. So we don't think Shanghai Hugong Electric GroupLtd's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Shanghai Hugong Electric GroupLtd , 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.