The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We can see that FAWER Automotive Parts Limited Company (SZSE:000030) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is FAWER Automotive Parts Limited's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 FAWER Automotive Parts Limited had CN¥899.6m of debt, an increase on CN¥812.6m, over one year. However, its balance sheet shows it holds CN¥1.43b in cash, so it actually has CN¥534.4m net cash.

How Strong Is FAWER Automotive Parts Limited's Balance Sheet?

We can see from the most recent balance sheet that FAWER Automotive Parts Limited had liabilities of CN¥6.54b falling due within a year, and liabilities of CN¥1.18b due beyond that. On the other hand, it had cash of CN¥1.43b and CN¥5.02b worth of receivables due within a year. So its liabilities total CN¥1.27b more than the combination of its cash and short-term receivables.

Given FAWER Automotive Parts Limited has a market capitalization of CN¥9.03b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, FAWER Automotive Parts Limited boasts net cash, so it's fair to say it does not have a heavy debt load!

Although FAWER Automotive Parts Limited made a loss at the EBIT level, last year, it was also good to see that it generated CN¥82m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since FAWER Automotive Parts Limited will need earnings to service that debt. 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 company can only pay off debt with cold hard cash, not accounting profits. While FAWER Automotive Parts Limited 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 year, FAWER Automotive Parts Limited saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While FAWER Automotive Parts Limited does have more liabilities than liquid assets, it also has net cash of CN¥534.4m. So we don't have any problem with FAWER Automotive Parts Limited's use of debt. 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. To that end, you should learn about the 3 warning signs we've spotted with FAWER Automotive Parts Limited (including 1 which shouldn't be ignored) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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