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. Importantly, Chongqing Zhifei Biological Products Co., Ltd. (SZSE:300122) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Chongqing Zhifei Biological Products Carry?

As you can see below, Chongqing Zhifei Biological Products had CN¥3.87b of debt at June 2024, down from CN¥4.30b a year prior. But on the other hand it also has CN¥5.59b in cash, leading to a CN¥1.72b net cash position.

A Look At Chongqing Zhifei Biological Products' Liabilities

According to the last reported balance sheet, Chongqing Zhifei Biological Products had liabilities of CN¥22.7b due within 12 months, and liabilities of CN¥667.3m due beyond 12 months. On the other hand, it had cash of CN¥5.59b and CN¥25.5b worth of receivables due within a year. So it can boast CN¥7.75b more liquid assets than total liabilities.

This surplus suggests that Chongqing Zhifei Biological Products has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Chongqing Zhifei Biological Products has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Chongqing Zhifei Biological Products's load is not too heavy, because its EBIT was down 26% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Chongqing Zhifei Biological Products 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Chongqing Zhifei 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. In the last three years, Chongqing Zhifei Biological Products's free cash flow amounted to 34% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Chongqing Zhifei Biological Products has net cash of CN¥1.72b, as well as more liquid assets than liabilities. So we are not troubled with Chongqing Zhifei Biological Products's debt use. There's no doubt that we learn most about debt from the balance sheet. 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 2 warning signs for Chongqing Zhifei Biological Products (of which 1 is concerning!) you should know about.

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.