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. Importantly, Shanghai Chlor-Alkali Chemical Co., Ltd. (SHSE:600618) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shanghai Chlor-Alkali Chemical

What Is Shanghai Chlor-Alkali Chemical's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2023 Shanghai Chlor-Alkali Chemical had debt of CN¥1.54b, up from CN¥1.23b in one year. But on the other hand it also has CN¥3.56b in cash, leading to a CN¥2.02b net cash position.

A Look At Shanghai Chlor-Alkali Chemical's Liabilities

Zooming in on the latest balance sheet data, we can see that Shanghai Chlor-Alkali Chemical had liabilities of CN¥1.77b due within 12 months and liabilities of CN¥1.47b due beyond that. Offsetting these obligations, it had cash of CN¥3.56b as well as receivables valued at CN¥824.3m due within 12 months. So it actually has CN¥1.14b more liquid assets than total liabilities.

This surplus suggests that Shanghai Chlor-Alkali Chemical has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Shanghai Chlor-Alkali Chemical has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Shanghai Chlor-Alkali Chemical's load is not too heavy, because its EBIT was down 49% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is Shanghai Chlor-Alkali Chemical's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Shanghai Chlor-Alkali Chemical 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, Shanghai Chlor-Alkali Chemical recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shanghai Chlor-Alkali Chemical has net cash of CN¥2.02b, as well as more liquid assets than liabilities. So we are not troubled with Shanghai Chlor-Alkali Chemical's debt use. 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. Be aware that Shanghai Chlor-Alkali Chemical is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.