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.' 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 Shanxi Lu'an Environmental Energy Development Co., Ltd. (SHSE:601699) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Shanxi Lu'an Environmental Energy Development Carry?

The image below, which you can click on for greater detail, shows that Shanxi Lu'an Environmental Energy Development had debt of CN¥19.9m at the end of September 2024, a reduction from CN¥2.26b over a year. However, its balance sheet shows it holds CN¥23.1b in cash, so it actually has CN¥23.1b net cash.

How Strong Is Shanxi Lu'an Environmental Energy Development's Balance Sheet?

The latest balance sheet data shows that Shanxi Lu'an Environmental Energy Development had liabilities of CN¥36.4b due within a year, and liabilities of CN¥7.36b falling due after that. Offsetting this, it had CN¥23.1b in cash and CN¥11.7b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.95b.

This deficit isn't so bad because Shanxi Lu'an Environmental Energy Development is worth CN¥43.0b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Shanxi Lu'an Environmental Energy Development also has more cash than debt, so we're pretty confident it can manage its debt safely.

It is just as well that Shanxi Lu'an Environmental Energy Development's load is not too heavy, because its EBIT was down 65% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shanxi Lu'an Environmental Energy Development can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shanxi Lu'an Environmental Energy Development 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. Happily for any shareholders, Shanxi Lu'an Environmental Energy Development actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While Shanxi Lu'an Environmental Energy Development does have more liabilities than liquid assets, it also has net cash of CN¥23.1b. The cherry on top was that in converted 109% of that EBIT to free cash flow, bringing in CN¥2.9b. So we don't have any problem with Shanxi Lu'an Environmental Energy Development's use of debt. 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, we've discovered 2 warning signs for Shanxi Lu'an Environmental Energy Development (1 is potentially serious!) that you should be aware of before investing here.

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.

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.