Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Jiangsu Shagang Co., Ltd. (SZSE:002075) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Jiangsu Shagang Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Jiangsu Shagang had debt of CN¥7.23b, up from CN¥2.66b in one year. However, its balance sheet shows it holds CN¥10.3b in cash, so it actually has CN¥3.07b net cash.

How Healthy Is Jiangsu Shagang's Balance Sheet?

We can see from the most recent balance sheet that Jiangsu Shagang had liabilities of CN¥11.1b falling due within a year, and liabilities of CN¥525.8m due beyond that. Offsetting these obligations, it had cash of CN¥10.3b as well as receivables valued at CN¥549.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥807.0m.

Of course, Jiangsu Shagang has a market capitalization of CN¥13.1b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Jiangsu Shagang also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact Jiangsu Shagang's saving grace is its low debt levels, because its EBIT has tanked 53% in the last twelve months. 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 it is Jiangsu Shagang'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Jiangsu Shagang 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 Shagang recorded free cash flow worth 53% 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 look at a company's total liabilities, it is very reassuring that Jiangsu Shagang has CN¥3.07b in net cash. So we are not troubled with Jiangsu Shagang's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Jiangsu Shagang you should be aware of, and 1 of them can't be ignored.

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.