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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Sichuan Kelun Pharmaceutical Co., Ltd. (SZSE:002422) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Sichuan Kelun Pharmaceutical Carry?

You can click the graphic below for the historical numbers, but it shows that Sichuan Kelun Pharmaceutical had CN¥5.16b of debt in September 2024, down from CN¥7.58b, one year before. But it also has CN¥7.08b in cash to offset that, meaning it has CN¥1.93b net cash.

A Look At Sichuan Kelun Pharmaceutical's Liabilities

Zooming in on the latest balance sheet data, we can see that Sichuan Kelun Pharmaceutical had liabilities of CN¥10.1b due within 12 months and liabilities of CN¥2.02b due beyond that. Offsetting these obligations, it had cash of CN¥7.08b as well as receivables valued at CN¥6.59b due within 12 months. So it can boast CN¥1.51b more liquid assets than total liabilities.

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

In addition to that, we're happy to report that Sichuan Kelun Pharmaceutical has boosted its EBIT by 54%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sichuan Kelun Pharmaceutical's ability to maintain a healthy balance sheet going forward. 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 Kelun Pharmaceutical 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. Over the last three years, Sichuan Kelun Pharmaceutical recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Sichuan Kelun Pharmaceutical has net cash of CN¥1.93b, as well as more liquid assets than liabilities. The cherry on top was that in converted 89% of that EBIT to free cash flow, bringing in CN¥2.4b. So is Sichuan Kelun Pharmaceutical's debt a risk? It doesn't seem so to us. 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 Kelun Pharmaceutical you should know about.

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.