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 note that Shenzhen Fortune Trend technology Co., Ltd. (SHSE:688318) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Shenzhen Fortune Trend technology Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Shenzhen Fortune Trend technology had debt of CN¥120.0m, up from none in one year. However, its balance sheet shows it holds CN¥1.99b in cash, so it actually has CN¥1.87b net cash.

How Strong Is Shenzhen Fortune Trend technology's Balance Sheet?

The latest balance sheet data shows that Shenzhen Fortune Trend technology had liabilities of CN¥262.6m due within a year, and liabilities of CN¥6.90m falling due after that. On the other hand, it had cash of CN¥1.99b and CN¥48.9m worth of receivables due within a year. So it actually has CN¥1.76b more liquid assets than total liabilities.

This surplus suggests that Shenzhen Fortune Trend technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Shenzhen Fortune Trend technology has more cash than debt is arguably a good indication that it can manage its debt safely.

In addition to that, we're happy to report that Shenzhen Fortune Trend technology has boosted its EBIT by 47%, thus reducing the spectre of future debt repayments. 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 Shenzhen Fortune Trend technology can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Shenzhen Fortune Trend technology 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. During the last three years, Shenzhen Fortune Trend technology generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shenzhen Fortune Trend technology has net cash of CN¥1.87b, as well as more liquid assets than liabilities. The cherry on top was that in converted 89% of that EBIT to free cash flow, bringing in CN¥176m. So we don't think Shenzhen Fortune Trend technology'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. To that end, you should be aware of the 1 warning sign we've spotted with Shenzhen Fortune Trend technology .

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.

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