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. Importantly, Jiangsu Zhengdan Chemical Industry Co., Ltd. (SZSE:300641) does carry debt. But should shareholders be worried about its use of debt?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is Jiangsu Zhengdan Chemical Industry's Debt?

As you can see below, Jiangsu Zhengdan Chemical Industry had CN¥190.8m of debt at September 2024, down from CN¥454.6m a year prior. However, it does have CN¥1.12b in cash offsetting this, leading to net cash of CN¥929.7m.

How Healthy Is Jiangsu Zhengdan Chemical Industry's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Jiangsu Zhengdan Chemical Industry had liabilities of CN¥446.6m due within 12 months and liabilities of CN¥2.56m due beyond that. Offsetting this, it had CN¥1.12b in cash and CN¥841.3m in receivables that were due within 12 months. So it actually has CN¥1.51b more liquid assets than total liabilities.

This short term liquidity is a sign that Jiangsu Zhengdan Chemical Industry could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Jiangsu Zhengdan Chemical Industry has more cash than debt is arguably a good indication that it can manage its debt safely.

Although Jiangsu Zhengdan Chemical Industry made a loss at the EBIT level, last year, it was also good to see that it generated CN¥940m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Jiangsu Zhengdan Chemical Industry will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Jiangsu Zhengdan Chemical Industry 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. Looking at the most recent year, Jiangsu Zhengdan Chemical Industry recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Jiangsu Zhengdan Chemical Industry has net cash of CN¥929.7m, as well as more liquid assets than liabilities. So we don't have any problem with Jiangsu Zhengdan Chemical Industry's use of debt. 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. For example Jiangsu Zhengdan Chemical Industry has 4 warning signs (and 1 which shouldn't be ignored) we think you should know about.

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.