Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Shanghai Material Trading Co., Ltd. (SHSE:600822) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

How Much Debt Does Shanghai Material Trading Carry?

You can click the graphic below for the historical numbers, but it shows that Shanghai Material Trading had CN¥59.2m of debt in September 2023, down from CN¥181.8m, one year before. However, it does have CN¥1.04b in cash offsetting this, leading to net cash of CN¥983.8m.

How Strong Is Shanghai Material Trading's Balance Sheet?

According to the last reported balance sheet, Shanghai Material Trading had liabilities of CN¥1.97b due within 12 months, and liabilities of CN¥231.5m due beyond 12 months. On the other hand, it had cash of CN¥1.04b and CN¥201.1m worth of receivables due within a year. So it has liabilities totalling CN¥956.5m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Shanghai Material Trading is worth CN¥3.99b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Shanghai Material Trading also has more cash than debt, so we're pretty confident it can manage its debt safely.

Although Shanghai Material Trading made a loss at the EBIT level, last year, it was also good to see that it generated CN¥29m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shanghai Material Trading will need earnings to service that debt. 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. Shanghai Material Trading 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, Shanghai Material Trading saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While Shanghai Material Trading does have more liabilities than liquid assets, it also has net cash of CN¥983.8m. So we are not troubled with Shanghai Material Trading's debt use. 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. For example Shanghai Material Trading has 2 warning signs (and 1 which shouldn't be ignored) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.