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 Guangdong Chj Industry Co.,Ltd. (SZSE:002345) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Guangdong Chj IndustryLtd's Net Debt?

As you can see below, Guangdong Chj IndustryLtd had CN¥513.0m of debt at June 2024, down from CN¥741.3m a year prior. However, it does have CN¥598.6m in cash offsetting this, leading to net cash of CN¥85.6m.

How Strong Is Guangdong Chj IndustryLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Guangdong Chj IndustryLtd had liabilities of CN¥1.82b due within 12 months and liabilities of CN¥188.0m due beyond that. Offsetting this, it had CN¥598.6m in cash and CN¥321.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.09b.

This deficit isn't so bad because Guangdong Chj IndustryLtd is worth CN¥4.02b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Guangdong Chj IndustryLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

Another good sign is that Guangdong Chj IndustryLtd has been able to increase its EBIT by 22% in twelve months, making it easier to pay down debt. 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 Guangdong Chj 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. Guangdong Chj IndustryLtd 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. Over the last three years, Guangdong Chj IndustryLtd recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

Although Guangdong Chj IndustryLtd's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥85.6m. And it impressed us with free cash flow of CN¥409m, being 82% of its EBIT. So we don't think Guangdong Chj IndustryLtd's use of debt is risky. 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. Be aware that Guangdong Chj IndustryLtd is showing 1 warning sign in our investment analysis , 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.