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.' 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 Shanghai Chemspec Corporation (SHSE:688602) makes use of debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Shanghai Chemspec's Net Debt?

As you can see below, at the end of September 2023, Shanghai Chemspec had CN¥220.5m of debt, up from CN¥200.4m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥1.16b in cash, so it actually has CN¥944.4m net cash.

A Look At Shanghai Chemspec's Liabilities

We can see from the most recent balance sheet that Shanghai Chemspec had liabilities of CN¥445.9m falling due within a year, and liabilities of CN¥116.0m due beyond that. Offsetting this, it had CN¥1.16b in cash and CN¥359.7m in receivables that were due within 12 months. So it can boast CN¥962.7m more liquid assets than total liabilities.

It's good to see that Shanghai Chemspec has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Shanghai Chemspec boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Shanghai Chemspec's saving grace is its low debt levels, because its EBIT has tanked 21% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shanghai Chemspec'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. While Shanghai Chemspec 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. During the last three years, Shanghai Chemspec burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shanghai Chemspec has net cash of CN¥944.4m, as well as more liquid assets than liabilities. So we are not troubled with Shanghai Chemspec's debt use. 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. Case in point: We've spotted 1 warning sign for Shanghai Chemspec you should be aware of.

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.