Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Explosive Co., Ltd. (SZSE:002096) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Explosive's Debt?

The image below, which you can click on for greater detail, shows that Explosive had debt of CN¥307.7m at the end of September 2023, a reduction from CN¥781.4m over a year. However, its balance sheet shows it holds CN¥2.04b in cash, so it actually has CN¥1.73b net cash.

How Healthy Is Explosive's Balance Sheet?

According to the last reported balance sheet, Explosive had liabilities of CN¥2.59b due within 12 months, and liabilities of CN¥823.0m due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.04b as well as receivables valued at CN¥3.01b due within 12 months. So it can boast CN¥1.63b more liquid assets than total liabilities.

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

And we also note warmly that Explosive grew its EBIT by 18% last year, making its debt load easier to handle. 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 Explosive 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Explosive 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, Explosive's free cash flow amounted to 50% 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 Explosive has net cash of CN¥1.73b, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 18% over the last year. So is Explosive's debt a risk? It doesn't seem so to us. 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. Case in point: We've spotted 2 warning signs for Explosive 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.