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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Shanxi Lanhua Sci-Tech Venture Co.,Ltd (SHSE:600123) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Shanxi Lanhua Sci-Tech VentureLtd's Net Debt?

As you can see below, at the end of March 2024, Shanxi Lanhua Sci-Tech VentureLtd had CN¥9.42b of debt, up from CN¥8.49b a year ago. Click the image for more detail. However, it also had CN¥6.12b in cash, and so its net debt is CN¥3.30b.

How Strong Is Shanxi Lanhua Sci-Tech VentureLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanxi Lanhua Sci-Tech VentureLtd had liabilities of CN¥9.54b due within 12 months and liabilities of CN¥6.41b due beyond that. Offsetting these obligations, it had cash of CN¥6.12b as well as receivables valued at CN¥1.68b due within 12 months. So its liabilities total CN¥8.15b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥12.7b, so it does suggest shareholders should keep an eye on Shanxi Lanhua Sci-Tech VentureLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Shanxi Lanhua Sci-Tech VentureLtd has a low net debt to EBITDA ratio of only 0.86. And its EBIT covers its interest expense a whopping 4k times over. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Shanxi Lanhua Sci-Tech VentureLtd if management cannot prevent a repeat of the 47% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shanxi Lanhua Sci-Tech VentureLtd 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shanxi Lanhua Sci-Tech VentureLtd recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Based on what we've seen Shanxi Lanhua Sci-Tech VentureLtd is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Shanxi Lanhua Sci-Tech VentureLtd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Shanxi Lanhua Sci-Tech VentureLtd you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com