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. Importantly, Chengdu RML Technology Co., Ltd. (SZSE:301050) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Chengdu RML Technology's Debt?

As you can see below, Chengdu RML Technology had CN¥30.0m of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds CN¥1.69b in cash, so it actually has CN¥1.66b net cash.

A Look At Chengdu RML Technology's Liabilities

The latest balance sheet data shows that Chengdu RML Technology had liabilities of CN¥1.85b due within a year, and liabilities of CN¥23.7m falling due after that. Offsetting these obligations, it had cash of CN¥1.69b as well as receivables valued at CN¥530.0m due within 12 months. So it can boast CN¥345.5m more liquid assets than total liabilities.

This short term liquidity is a sign that Chengdu RML Technology could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Chengdu RML Technology boasts net cash, so it's fair to say it does not have a heavy debt load!

The good news is that Chengdu RML Technology has increased its EBIT by 5.5% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Chengdu RML Technology's ability to maintain a healthy balance sheet going forward. 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. Chengdu RML Technology 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. Looking at the most recent three years, Chengdu RML Technology recorded free cash flow of 37% of its EBIT, which is weaker 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 Chengdu RML Technology has net cash of CN¥1.66b, as well as more liquid assets than liabilities. And it also grew its EBIT by 5.5% over the last year. So we are not troubled with Chengdu RML Technology's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Chengdu RML Technology that you should be aware of.

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.