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 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 Chaozhou Three-Circle (Group) Co.,Ltd. (SZSE:300408) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Chaozhou Three-Circle (Group)Ltd's Debt?

As you can see below, at the end of September 2023, Chaozhou Three-Circle (Group)Ltd had CN¥895.8m of debt, up from CN¥99.5m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥9.90b in cash, so it actually has CN¥9.01b net cash.

How Healthy Is Chaozhou Three-Circle (Group)Ltd's Balance Sheet?

According to the last reported balance sheet, Chaozhou Three-Circle (Group)Ltd had liabilities of CN¥2.27b due within 12 months, and liabilities of CN¥1.09b due beyond 12 months. Offsetting these obligations, it had cash of CN¥9.90b as well as receivables valued at CN¥2.14b due within 12 months. So it can boast CN¥8.69b more liquid assets than total liabilities.

This surplus suggests that Chaozhou Three-Circle (Group)Ltd is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that Chaozhou Three-Circle (Group)Ltd has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Chaozhou Three-Circle (Group)Ltd's load is not too heavy, because its EBIT was down 42% over the last year. 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 future earnings, more than anything, that will determine Chaozhou Three-Circle (Group)Ltd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Chaozhou Three-Circle (Group)Ltd 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. In the last three years, Chaozhou Three-Circle (Group)Ltd's free cash flow amounted to 20% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While it is always sensible to investigate a company's debt, in this case Chaozhou Three-Circle (Group)Ltd has CN¥9.01b in net cash and a decent-looking balance sheet. So we are not troubled with Chaozhou Three-Circle (Group)Ltd's debt use. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Chaozhou Three-Circle (Group)Ltd you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.