The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Zhejiang Dun'an Artificial Environment Co., Ltd (SZSE:002011) does carry debt. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is Zhejiang Dun'an Artificial Environment's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Zhejiang Dun'an Artificial Environment had debt of CN¥1.66b, up from CN¥1.37b in one year. But on the other hand it also has CN¥2.72b in cash, leading to a CN¥1.05b net cash position.

How Healthy Is Zhejiang Dun'an Artificial Environment's Balance Sheet?

According to the last reported balance sheet, Zhejiang Dun'an Artificial Environment had liabilities of CN¥5.31b due within 12 months, and liabilities of CN¥878.7m due beyond 12 months. On the other hand, it had cash of CN¥2.72b and CN¥4.21b worth of receivables due within a year. So it can boast CN¥736.8m more liquid assets than total liabilities.

This short term liquidity is a sign that Zhejiang Dun'an Artificial Environment could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Zhejiang Dun'an Artificial Environment has more cash than debt is arguably a good indication that it can manage its debt safely.

Another good sign is that Zhejiang Dun'an Artificial Environment has been able to increase its EBIT by 26% in twelve months, making it easier to pay down debt. 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 Zhejiang Dun'an Artificial Environment 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Zhejiang Dun'an Artificial Environment 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. During the last three years, Zhejiang Dun'an Artificial Environment produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case Zhejiang Dun'an Artificial Environment has CN¥1.05b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 79% of that EBIT to free cash flow, bringing in CN¥581m. So is Zhejiang Dun'an Artificial Environment's debt a risk? It doesn't seem so to us. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Zhejiang Dun'an Artificial Environment's earnings per share history for free.

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.

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