David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Shandong Sacred Sun Power Sources Co.,Ltd (SZSE:002580) makes use of debt. 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Shandong Sacred Sun Power SourcesLtd Carry?

As you can see below, at the end of September 2024, Shandong Sacred Sun Power SourcesLtd had CN¥399.3m of debt, up from CN¥302.8m a year ago. Click the image for more detail. However, it does have CN¥510.8m in cash offsetting this, leading to net cash of CN¥111.5m.

How Healthy Is Shandong Sacred Sun Power SourcesLtd's Balance Sheet?

According to the last reported balance sheet, Shandong Sacred Sun Power SourcesLtd had liabilities of CN¥817.4m due within 12 months, and liabilities of CN¥432.4m due beyond 12 months. Offsetting this, it had CN¥510.8m in cash and CN¥1.16b in receivables that were due within 12 months. So it actually has CN¥423.7m more liquid assets than total liabilities.

This short term liquidity is a sign that Shandong Sacred Sun Power SourcesLtd could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Shandong Sacred Sun Power SourcesLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Shandong Sacred Sun Power SourcesLtd's saving grace is its low debt levels, because its EBIT has tanked 30% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shandong Sacred Sun Power SourcesLtd'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shandong Sacred Sun Power SourcesLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Shandong Sacred Sun Power SourcesLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shandong Sacred Sun Power SourcesLtd has net cash of CN¥111.5m, as well as more liquid assets than liabilities. So although we see some areas for improvement, we're not too worried about Shandong Sacred Sun Power SourcesLtd's balance sheet. 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 2 warning signs we've spotted with Shandong Sacred Sun Power SourcesLtd .

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.