David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that Shenzhen Prince New Materials Co.,Ltd. (SZSE:002735) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Shenzhen Prince New MaterialsLtd's Net Debt?

The image below, which you can click on for greater detail, shows that Shenzhen Prince New MaterialsLtd had debt of CN¥268.9m at the end of March 2024, a reduction from CN¥347.0m over a year. However, its balance sheet shows it holds CN¥776.8m in cash, so it actually has CN¥507.9m net cash.

How Strong Is Shenzhen Prince New MaterialsLtd's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Prince New MaterialsLtd had liabilities of CN¥880.3m falling due within a year, and liabilities of CN¥72.9m due beyond that. Offsetting these obligations, it had cash of CN¥776.8m as well as receivables valued at CN¥814.8m due within 12 months. So it can boast CN¥638.5m more liquid assets than total liabilities.

This short term liquidity is a sign that Shenzhen Prince New MaterialsLtd could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Shenzhen Prince New MaterialsLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

On top of that, Shenzhen Prince New MaterialsLtd grew its EBIT by 53% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shenzhen Prince New MaterialsLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Shenzhen Prince New MaterialsLtd 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. Considering the last three years, Shenzhen Prince New MaterialsLtd actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shenzhen Prince New MaterialsLtd has net cash of CN¥507.9m, as well as more liquid assets than liabilities. And we liked the look of last year's 53% year-on-year EBIT growth. So we don't think Shenzhen Prince New MaterialsLtd's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Shenzhen Prince New MaterialsLtd has 3 warning signs (and 2 which don't sit too well with us) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.