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 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 China XD Electric Co., Ltd (SHSE:601179) makes use of debt. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is China XD Electric's Net Debt?

As you can see below, at the end of September 2023, China XD Electric had CN¥1.84b of debt, up from CN¥374.6m a year ago. Click the image for more detail. But it also has CN¥8.64b in cash to offset that, meaning it has CN¥6.80b net cash.

How Healthy Is China XD Electric's Balance Sheet?

We can see from the most recent balance sheet that China XD Electric had liabilities of CN¥16.2b falling due within a year, and liabilities of CN¥1.30b due beyond that. Offsetting this, it had CN¥8.64b in cash and CN¥13.3b in receivables that were due within 12 months. So it actually has CN¥4.43b more liquid assets than total liabilities.

This excess liquidity suggests that China XD Electric is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, China XD Electric boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for China XD Electric if management cannot prevent a repeat of the 33% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 China XD Electric can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. China XD Electric 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 last three years, China XD Electric reported free cash flow worth 18% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case China XD Electric has CN¥6.80b in net cash and a decent-looking balance sheet. So we don't have any problem with China XD Electric's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with China XD Electric , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.