Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Jinzi Ham Co.,Ltd. (SZSE:002515) makes use of debt. But should shareholders be worried about its use of debt?

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 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Jinzi HamLtd's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Jinzi HamLtd had debt of CN¥100.1m, up from none in one year. However, its balance sheet shows it holds CN¥1.42b in cash, so it actually has CN¥1.32b net cash.

How Strong Is Jinzi HamLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Jinzi HamLtd had liabilities of CN¥147.0m due within 12 months and liabilities of CN¥11.3m due beyond that. Offsetting these obligations, it had cash of CN¥1.42b as well as receivables valued at CN¥31.0m due within 12 months. So it can boast CN¥1.29b more liquid assets than total liabilities.

This surplus suggests that Jinzi HamLtd is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Jinzi HamLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Jinzi HamLtd's load is not too heavy, because its EBIT was down 21% 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 you can't view debt in total isolation; since Jinzi HamLtd will need earnings to service that debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. While Jinzi HamLtd 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. Over the last two years, Jinzi HamLtd actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Jinzi HamLtd has net cash of CN¥1.32b, as well as more liquid assets than liabilities. The cherry on top was that in converted 268% of that EBIT to free cash flow, bringing in -CN¥7.8m. So is Jinzi HamLtd'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. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Jinzi HamLtd 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.