Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Chengdu Kanghua Biological Products Co., Ltd. (SZSE:300841) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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. 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 Chengdu Kanghua Biological Products's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Chengdu Kanghua Biological Products had debt of CN¥210.2m, up from CN¥138.1m in one year. But it also has CN¥1.06b in cash to offset that, meaning it has CN¥847.6m net cash.

How Strong Is Chengdu Kanghua Biological Products' Balance Sheet?

According to the last reported balance sheet, Chengdu Kanghua Biological Products had liabilities of CN¥588.5m due within 12 months, and liabilities of CN¥12.1m due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.06b as well as receivables valued at CN¥1.38b due within 12 months. So it can boast CN¥1.84b more liquid assets than total liabilities.

This excess liquidity suggests that Chengdu Kanghua Biological Products is taking a careful approach to debt. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that Chengdu Kanghua Biological Products has more cash than debt is arguably a good indication that it can manage its debt safely.

Also good is that Chengdu Kanghua Biological Products grew its EBIT at 16% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Chengdu Kanghua Biological Products 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Chengdu Kanghua Biological Products 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, Chengdu Kanghua Biological Products reported free cash flow worth 8.7% 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 we empathize with investors who find debt concerning, you should keep in mind that Chengdu Kanghua Biological Products has net cash of CN¥847.6m, as well as more liquid assets than liabilities. And we liked the look of last year's 16% year-on-year EBIT growth. So we don't think Chengdu Kanghua Biological Products's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Chengdu Kanghua Biological Products you should know about.

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.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com