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.' 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 Changzhou Shichuang Energy Co.,Ltd. (SHSE:688429) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 Changzhou Shichuang EnergyLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Changzhou Shichuang EnergyLtd had debt of CN¥371.8m, up from CN¥6.49m in one year. But it also has CN¥1.39b in cash to offset that, meaning it has CN¥1.01b net cash.

How Strong Is Changzhou Shichuang EnergyLtd's Balance Sheet?

We can see from the most recent balance sheet that Changzhou Shichuang EnergyLtd had liabilities of CN¥1.59b falling due within a year, and liabilities of CN¥169.2m due beyond that. Offsetting this, it had CN¥1.39b in cash and CN¥430.8m in receivables that were due within 12 months. So it can boast CN¥57.8m more liquid assets than total liabilities.

This state of affairs indicates that Changzhou Shichuang EnergyLtd's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥6.29b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Changzhou Shichuang EnergyLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Changzhou Shichuang EnergyLtd's load is not too heavy, because its EBIT was down 88% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Changzhou Shichuang EnergyLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Changzhou Shichuang EnergyLtd 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 three years, Changzhou Shichuang EnergyLtd 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 it is always sensible to investigate a company's debt, in this case Changzhou Shichuang EnergyLtd has CN¥1.01b in net cash and a decent-looking balance sheet. So although we see some areas for improvement, we're not too worried about Changzhou Shichuang EnergyLtd's balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Changzhou Shichuang EnergyLtd (at least 2 which are concerning) , and understanding them should be part of your investment process.

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.