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.' 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. We note that Sichuan Injet Electric Co., Ltd. (SZSE:300820) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Sichuan Injet Electric's Debt?

As you can see below, Sichuan Injet Electric had CN¥20.0m of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥902.8m in cash offsetting this, leading to net cash of CN¥882.8m.

A Look At Sichuan Injet Electric's Liabilities

We can see from the most recent balance sheet that Sichuan Injet Electric had liabilities of CN¥1.72b falling due within a year, and liabilities of CN¥37.6m due beyond that. Offsetting this, it had CN¥902.8m in cash and CN¥679.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥175.0m.

Given Sichuan Injet Electric has a market capitalization of CN¥8.33b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Sichuan Injet Electric also has more cash than debt, so we're pretty confident it can manage its debt safely.

Another good sign is that Sichuan Injet Electric has been able to increase its EBIT by 20% in twelve months, making it easier to pay down 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 Sichuan Injet Electric 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. Sichuan Injet Electric 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. In the last three years, Sichuan Injet Electric created free cash flow amounting to 15% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

We could understand if investors are concerned about Sichuan Injet Electric's liabilities, but we can be reassured by the fact it has has net cash of CN¥882.8m. And it impressed us with its EBIT growth of 20% over the last year. So we don't have any problem with Sichuan Injet Electric's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with Sichuan Injet Electric .

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.