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 Sichuan Changhong Electric Co.,Ltd. (SHSE:600839) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Sichuan Changhong ElectricLtd's Debt?

As you can see below, Sichuan Changhong ElectricLtd had CN¥18.5b 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¥27.1b in cash offsetting this, leading to net cash of CN¥8.64b.

A Look At Sichuan Changhong ElectricLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Sichuan Changhong ElectricLtd had liabilities of CN¥66.2b due within 12 months and liabilities of CN¥4.59b due beyond that. Offsetting this, it had CN¥27.1b in cash and CN¥19.4b in receivables that were due within 12 months. So it has liabilities totalling CN¥24.3b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥26.1b, so it does suggest shareholders should keep an eye on Sichuan Changhong ElectricLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. While it does have liabilities worth noting, Sichuan Changhong ElectricLtd also has more cash than debt, so we're pretty confident it can manage its debt safely.

But the bad news is that Sichuan Changhong ElectricLtd has seen its EBIT plunge 18% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sichuan Changhong ElectricLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Sichuan Changhong ElectricLtd 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. Happily for any shareholders, Sichuan Changhong ElectricLtd actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

Although Sichuan Changhong ElectricLtd'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¥8.64b. And it impressed us with free cash flow of CN¥1.2b, being 201% of its EBIT. So we don't have any problem with Sichuan Changhong ElectricLtd's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 Sichuan Changhong ElectricLtd you should know about.

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.