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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Shanghai Chlor-Alkali Chemical Co., Ltd. (SHSE:600618) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
Check out our latest analysis for Shanghai Chlor-Alkali Chemical
What Is Shanghai Chlor-Alkali Chemical's Debt?
The image below, which you can click on for greater detail, shows that at June 2023 Shanghai Chlor-Alkali Chemical had debt of CN¥1.78b, up from CN¥1.63b in one year. But on the other hand it also has CN¥3.73b in cash, leading to a CN¥1.94b net cash position.
A Look At Shanghai Chlor-Alkali Chemical's Liabilities
The latest balance sheet data shows that Shanghai Chlor-Alkali Chemical had liabilities of CN¥2.25b due within a year, and liabilities of CN¥1.47b falling due after that. Offsetting these obligations, it had cash of CN¥3.73b as well as receivables valued at CN¥611.2m due within 12 months. So it actually has CN¥612.5m more liquid assets than total liabilities.
This short term liquidity is a sign that Shanghai Chlor-Alkali Chemical could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Shanghai Chlor-Alkali Chemical has more cash than debt is arguably a good indication that it can manage its debt safely.
It is just as well that Shanghai Chlor-Alkali Chemical's load is not too heavy, because its EBIT was down 65% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shanghai Chlor-Alkali Chemical's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Shanghai Chlor-Alkali Chemical 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. Considering the last three years, Shanghai Chlor-Alkali Chemical actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
Summing Up
While it is always sensible to investigate a company's debt, in this case Shanghai Chlor-Alkali Chemical has CN¥1.94b in net cash and a decent-looking balance sheet. So although we see some areas for improvement, we're not too worried about Shanghai Chlor-Alkali Chemical's balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Shanghai Chlor-Alkali Chemical that you should be aware of before investing here.
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.