Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Arctech Solar Holding Co., Ltd. (SHSE:688408) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Arctech Solar Holding's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Arctech Solar Holding had CN¥521.3m of debt, an increase on CN¥411.1m, over one year. However, it does have CN¥1.82b in cash offsetting this, leading to net cash of CN¥1.30b.

A Look At Arctech Solar Holding's Liabilities

We can see from the most recent balance sheet that Arctech Solar Holding had liabilities of CN¥3.90b falling due within a year, and liabilities of CN¥332.2m due beyond that. On the other hand, it had cash of CN¥1.82b and CN¥1.72b worth of receivables due within a year. So its liabilities total CN¥687.6m more than the combination of its cash and short-term receivables.

Given Arctech Solar Holding has a market capitalization of CN¥11.9b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Arctech Solar Holding also has more cash than debt, so we're pretty confident it can manage its debt safely.

Although Arctech Solar Holding made a loss at the EBIT level, last year, it was also good to see that it generated CN¥209m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Arctech Solar Holding can strengthen its balance sheet over time. 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. Arctech Solar Holding 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 year, Arctech Solar Holding actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Arctech Solar Holding has CN¥1.30b in net cash. The cherry on top was that in converted 176% of that EBIT to free cash flow, bringing in CN¥368m. So is Arctech Solar Holding's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Arctech Solar Holding you should know about.

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.