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 can see that Shenzhen Zhaowei Machinery & Electronics Co., Ltd. (SZSE:003021) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Shenzhen Zhaowei Machinery & Electronics's Debt?

The chart below, which you can click on for greater detail, shows that Shenzhen Zhaowei Machinery & Electronics had CN¥40.2m in debt in September 2024; about the same as the year before. However, its balance sheet shows it holds CN¥1.07b in cash, so it actually has CN¥1.03b net cash.

How Strong Is Shenzhen Zhaowei Machinery & Electronics' Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Zhaowei Machinery & Electronics had liabilities of CN¥713.8m falling due within a year, and liabilities of CN¥87.9m due beyond that. Offsetting these obligations, it had cash of CN¥1.07b as well as receivables valued at CN¥510.2m due within 12 months. So it can boast CN¥774.9m more liquid assets than total liabilities.

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

Also positive, Shenzhen Zhaowei Machinery & Electronics grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. 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 Zhaowei Machinery & Electronics 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. Shenzhen Zhaowei Machinery & Electronics 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. Considering the last three years, Shenzhen Zhaowei Machinery & Electronics actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shenzhen Zhaowei Machinery & Electronics has net cash of CN¥1.03b, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 29% over the last year. So we don't have any problem with Shenzhen Zhaowei Machinery & Electronics's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Shenzhen Zhaowei Machinery & Electronics you should be aware of.

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.