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. As with many other companies Shanghai Mechanical & Electrical Industry Co.,Ltd. (SHSE:600835) makes use of debt. But is this debt a concern to shareholders?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Shanghai Mechanical & Electrical IndustryLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Shanghai Mechanical & Electrical IndustryLtd had CN¥61.3m of debt, an increase on CN¥56.0m, over one year. However, its balance sheet shows it holds CN¥12.8b in cash, so it actually has CN¥12.8b net cash.

How Healthy Is Shanghai Mechanical & Electrical IndustryLtd's Balance Sheet?

The latest balance sheet data shows that Shanghai Mechanical & Electrical IndustryLtd had liabilities of CN¥20.6b due within a year, and liabilities of CN¥374.7m falling due after that. Offsetting these obligations, it had cash of CN¥12.8b as well as receivables valued at CN¥6.89b due within 12 months. So its liabilities total CN¥1.24b more than the combination of its cash and short-term receivables.

Of course, Shanghai Mechanical & Electrical IndustryLtd has a market capitalization of CN¥11.9b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Shanghai Mechanical & Electrical IndustryLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

While Shanghai Mechanical & Electrical IndustryLtd doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shanghai Mechanical & Electrical IndustryLtd 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. While Shanghai Mechanical & Electrical IndustryLtd 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 Mechanical & Electrical IndustryLtd actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While Shanghai Mechanical & Electrical IndustryLtd does have more liabilities than liquid assets, it also has net cash of CN¥12.8b. And it impressed us with free cash flow of CN¥936m, being 116% of its EBIT. So we don't think Shanghai Mechanical & Electrical IndustryLtd's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Shanghai Mechanical & Electrical IndustryLtd is showing 1 warning sign in our investment analysis , you should know about...

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.