Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Chengdu Galaxy Magnets Co.,Ltd. (SZSE:300127) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Chengdu Galaxy MagnetsLtd

What Is Chengdu Galaxy MagnetsLtd's Debt?

As you can see below, at the end of September 2023, Chengdu Galaxy MagnetsLtd had CN¥70.0m of debt, up from none a year ago. Click the image for more detail. However, it does have CN¥531.2m in cash offsetting this, leading to net cash of CN¥461.2m.

How Healthy Is Chengdu Galaxy MagnetsLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chengdu Galaxy MagnetsLtd had liabilities of CN¥119.3m due within 12 months and liabilities of CN¥4.16m due beyond that. Offsetting this, it had CN¥531.2m in cash and CN¥331.1m in receivables that were due within 12 months. So it can boast CN¥738.8m more liquid assets than total liabilities.

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

On the other hand, Chengdu Galaxy MagnetsLtd saw its EBIT drop by 7.4% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Chengdu Galaxy MagnetsLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Chengdu Galaxy MagnetsLtd 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, Chengdu Galaxy MagnetsLtd's free cash flow amounted to 29% 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 Chengdu Galaxy MagnetsLtd has CN¥461.2m in net cash and a decent-looking balance sheet. So we don't have any problem with Chengdu Galaxy MagnetsLtd's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Chengdu Galaxy MagnetsLtd has 1 warning sign we think you should be aware of.

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.