Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that China Automotive Engineering Research Institute Co., Ltd. (SHSE:601965) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does China Automotive Engineering Research Institute Carry?

The image below, which you can click on for greater detail, shows that at March 2024 China Automotive Engineering Research Institute had debt of CN¥53.0m, up from CN¥4.30m in one year. But on the other hand it also has CN¥2.04b in cash, leading to a CN¥1.98b net cash position.

How Strong Is China Automotive Engineering Research Institute's Balance Sheet?

The latest balance sheet data shows that China Automotive Engineering Research Institute had liabilities of CN¥1.69b due within a year, and liabilities of CN¥464.8m falling due after that. Offsetting these obligations, it had cash of CN¥2.04b as well as receivables valued at CN¥2.02b due within 12 months. So it actually has CN¥1.90b more liquid assets than total liabilities.

This surplus suggests that China Automotive Engineering Research Institute has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that China Automotive Engineering Research Institute has more cash than debt is arguably a good indication that it can manage its debt safely.

Also good is that China Automotive Engineering Research Institute grew its EBIT at 15% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Automotive Engineering Research Institute 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. China Automotive Engineering Research Institute 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. Looking at the most recent three years, China Automotive Engineering Research Institute recorded free cash flow of 38% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While it is always sensible to investigate a company's debt, in this case China Automotive Engineering Research Institute has CN¥1.98b in net cash and a decent-looking balance sheet. And we liked the look of last year's 15% year-on-year EBIT growth. So is China Automotive Engineering Research Institute's debt a risk? It doesn't seem so to us. 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. To that end, you should be aware of the 1 warning sign we've spotted with China Automotive Engineering Research Institute .

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.