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 Shandong Iron and Steel Company Ltd. (SHSE:600022) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. 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 Shandong Iron and Steel's Debt?

As you can see below, Shandong Iron and Steel had CN¥11.2b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥6.22b in cash leading to net debt of about CN¥5.02b.

How Strong Is Shandong Iron and Steel's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shandong Iron and Steel had liabilities of CN¥31.7b due within 12 months and liabilities of CN¥5.98b due beyond that. On the other hand, it had cash of CN¥6.22b and CN¥2.08b worth of receivables due within a year. So it has liabilities totalling CN¥29.3b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥15.9b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Shandong Iron and Steel would likely require a major re-capitalisation if it had to pay its creditors today. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shandong Iron and Steel 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.

In the last year Shandong Iron and Steel had a loss before interest and tax, and actually shrunk its revenue by 7.3%, to CN¥89b. We would much prefer see growth.

Caveat Emptor

Over the last twelve months Shandong Iron and Steel produced an earnings before interest and tax (EBIT) loss. To be specific the EBIT loss came in at CN¥915m. When we look at that alongside the significant liabilities, we're not particularly confident about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. For example, we would not want to see a repeat of last year's loss of CN¥1.1b. In the meantime, we consider the stock to be risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Shandong Iron and Steel you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.