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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that China XD Electric Co., Ltd (SHSE:601179) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is China XD Electric's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 China XD Electric had debt of CN¥882.9m, up from CN¥725.7m in one year. But it also has CN¥10.3b in cash to offset that, meaning it has CN¥9.37b net cash.

How Strong Is China XD Electric's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China XD Electric had liabilities of CN¥17.6b due within 12 months and liabilities of CN¥1.90b due beyond that. On the other hand, it had cash of CN¥10.3b and CN¥15.8b worth of receivables due within a year. So it actually has CN¥6.50b more liquid assets than total liabilities.

This short term liquidity is a sign that China XD Electric could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, China XD Electric boasts net cash, so it's fair to say it does not have a heavy debt load!

Even more impressive was the fact that China XD Electric grew its EBIT by 112% over twelve months. That boost will make it even easier to pay down debt going forward. 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 China XD 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. China XD 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. During the last three years, China XD Electric generated free cash flow amounting to a very robust 96% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case China XD Electric has CN¥9.37b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 96% of that EBIT to free cash flow, bringing in CN¥3.4b. So is China XD Electric's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - China XD Electric has 1 warning sign we think you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.