Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies Jiangsu Huachang Chemical Co., Ltd (SZSE:002274) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Jiangsu Huachang Chemical's Net Debt?

As you can see below, Jiangsu Huachang Chemical had CN¥130.2m of debt at June 2024, down from CN¥640.2m a year prior. But on the other hand it also has CN¥589.7m in cash, leading to a CN¥459.5m net cash position.

How Strong Is Jiangsu Huachang Chemical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Jiangsu Huachang Chemical had liabilities of CN¥2.18b due within 12 months and liabilities of CN¥6.14m due beyond that. Offsetting this, it had CN¥589.7m in cash and CN¥1.66b in receivables that were due within 12 months. So it actually has CN¥57.3m more liquid assets than total liabilities.

Having regard to Jiangsu Huachang Chemical's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥7.80b company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, Jiangsu Huachang Chemical boasts net cash, so it's fair to say it does not have a heavy debt load!

In addition to that, we're happy to report that Jiangsu Huachang Chemical has boosted its EBIT by 67%, thus reducing the spectre of future debt repayments. 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 Jiangsu Huachang Chemical 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. Jiangsu Huachang Chemical 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 most recent three years, Jiangsu Huachang Chemical recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case Jiangsu Huachang Chemical has CN¥459.5m in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 67% over the last year. So we don't think Jiangsu Huachang Chemical's use of debt is risky. 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. For example - Jiangsu Huachang Chemical has 1 warning sign we think you should be aware of.

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.

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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.