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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Sinolong New Materials Co., Ltd. (SZSE:301565) makes use of debt. But the real question is whether this debt is making the company risky.

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. 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 Sinolong New Materials's Debt?

As you can see below, at the end of June 2024, Sinolong New Materials had CN¥371.8m of debt, up from CN¥328.3m a year ago. Click the image for more detail. But it also has CN¥1.11b in cash to offset that, meaning it has CN¥743.2m net cash.

A Look At Sinolong New Materials' Liabilities

We can see from the most recent balance sheet that Sinolong New Materials had liabilities of CN¥1.11b falling due within a year, and liabilities of CN¥219.2m due beyond that. Offsetting these obligations, it had cash of CN¥1.11b as well as receivables valued at CN¥320.6m due within 12 months. So it can boast CN¥106.2m more liquid assets than total liabilities.

Having regard to Sinolong New Materials' size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥8.80b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Sinolong New Materials has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Sinolong New Materials's saving grace is its low debt levels, because its EBIT has tanked 27% 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 you can't view debt in total isolation; since Sinolong New Materials 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Sinolong New Materials 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. During the last three years, Sinolong New Materials produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Sinolong New Materials has net cash of CN¥743.2m, as well as more liquid assets than liabilities. So we don't have any problem with Sinolong New Materials's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Sinolong New Materials , and understanding them should be part of your investment process.

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.