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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Sichuan Changhong Electric Co.,Ltd. (SHSE:600839) does use debt in its business. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Sichuan Changhong ElectricLtd's Net Debt?

As you can see below, at the end of March 2024, Sichuan Changhong ElectricLtd had CN¥19.7b of debt, up from CN¥18.5b a year ago. Click the image for more detail. But it also has CN¥25.2b in cash to offset that, meaning it has CN¥5.46b net cash.

A Look At Sichuan Changhong ElectricLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Sichuan Changhong ElectricLtd had liabilities of CN¥65.4b due within 12 months and liabilities of CN¥5.10b due beyond that. On the other hand, it had cash of CN¥25.2b and CN¥20.2b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥25.2b.

Given this deficit is actually higher than the company's market capitalization of CN¥20.7b, we think shareholders really should watch Sichuan Changhong ElectricLtd's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Sichuan Changhong ElectricLtd boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

Also good is that Sichuan Changhong ElectricLtd grew its EBIT at 15% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sichuan Changhong ElectricLtd'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 company can only pay off debt with cold hard cash, not accounting profits. Sichuan Changhong ElectricLtd 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 three years, Sichuan Changhong ElectricLtd actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While Sichuan Changhong ElectricLtd does have more liabilities than liquid assets, it also has net cash of CN¥5.46b. The cherry on top was that in converted 166% of that EBIT to free cash flow, bringing in CN¥1.4b. So we don't have any problem with Sichuan Changhong ElectricLtd's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Sichuan Changhong ElectricLtd that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com