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 note that Zhende Medical Co., Ltd. (SHSE:603301) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Zhende Medical's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Zhende Medical had debt of CN¥937.7m, up from CN¥662.7m in one year. However, it does have CN¥1.11b in cash offsetting this, leading to net cash of CN¥174.0m.

How Strong Is Zhende Medical's Balance Sheet?

The latest balance sheet data shows that Zhende Medical had liabilities of CN¥1.27b due within a year, and liabilities of CN¥762.8m falling due after that. Offsetting this, it had CN¥1.11b in cash and CN¥1.03b in receivables that were due within 12 months. So it actually has CN¥100.8m more liquid assets than total liabilities.

This state of affairs indicates that Zhende Medical's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥5.59b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Zhende Medical has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Zhende Medical if management cannot prevent a repeat of the 67% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Zhende Medical's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Zhende Medical 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. Over the last three years, Zhende Medical barely recorded positive free cash flow, in total. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Zhende Medical has net cash of CN¥174.0m, as well as more liquid assets than liabilities. So we are not troubled with Zhende Medical's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Zhende Medical that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.