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. As with many other companies Shanghai Datun Energy Resources Co., Ltd. (SHSE:600508) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. 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 Shanghai Datun Energy Resources's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Shanghai Datun Energy Resources had debt of CN¥1.39b, up from CN¥1.29b in one year. However, its balance sheet shows it holds CN¥2.72b in cash, so it actually has CN¥1.33b net cash.

How Healthy Is Shanghai Datun Energy Resources' Balance Sheet?

We can see from the most recent balance sheet that Shanghai Datun Energy Resources had liabilities of CN¥3.43b falling due within a year, and liabilities of CN¥3.83b due beyond that. On the other hand, it had cash of CN¥2.72b and CN¥1.23b worth of receivables due within a year. So its liabilities total CN¥3.31b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Shanghai Datun Energy Resources has a market capitalization of CN¥9.27b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Shanghai Datun Energy Resources boasts net cash, so it's fair to say it does not have a heavy debt load!

Importantly, Shanghai Datun Energy Resources's EBIT fell a jaw-dropping 76% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Shanghai Datun Energy Resources'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Shanghai Datun Energy Resources 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 most recent three years, Shanghai Datun Energy Resources recorded free cash flow worth 59% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

Although Shanghai Datun Energy Resources'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¥1.33b. So while Shanghai Datun Energy Resources does not have a great balance sheet, it's certainly not too bad. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with Shanghai Datun Energy Resources (including 1 which is a bit concerning) .

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.