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 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. We can see that Top Energy Company Ltd.Shanxi (SHSE:600780) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Top Energy CompanyShanxi's Debt?

You can click the graphic below for the historical numbers, but it shows that Top Energy CompanyShanxi had CN¥346.3m of debt in June 2024, down from CN¥506.3m, one year before. But on the other hand it also has CN¥2.46b in cash, leading to a CN¥2.12b net cash position.

How Strong Is Top Energy CompanyShanxi's Balance Sheet?

According to the last reported balance sheet, Top Energy CompanyShanxi had liabilities of CN¥2.34b due within 12 months, and liabilities of CN¥636.5m due beyond 12 months. On the other hand, it had cash of CN¥2.46b and CN¥925.7m worth of receivables due within a year. So it can boast CN¥410.3m more liquid assets than total liabilities.

This surplus suggests that Top Energy CompanyShanxi has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Top Energy CompanyShanxi boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Top Energy CompanyShanxi's saving grace is its low debt levels, because its EBIT has tanked 37% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is Top Energy CompanyShanxi'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Top Energy CompanyShanxi 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, Top Energy CompanyShanxi actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While it is always sensible to investigate a company's debt, in this case Top Energy CompanyShanxi has CN¥2.12b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 132% of that EBIT to free cash flow, bringing in CN¥669m. So we don't have any problem with Top Energy CompanyShanxi's use of debt. 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. To that end, you should be aware of the 1 warning sign we've spotted with Top Energy CompanyShanxi .

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.