David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Weihai Honglin Electronic Co., Ltd. (SZSE:301439) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Weihai Honglin Electronic's Debt?

The image below, which you can click on for greater detail, shows that Weihai Honglin Electronic had debt of CN¥41.5m at the end of March 2024, a reduction from CN¥141.9m over a year. However, it does have CN¥998.4m in cash offsetting this, leading to net cash of CN¥956.9m.

How Strong Is Weihai Honglin Electronic's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Weihai Honglin Electronic had liabilities of CN¥726.8m due within 12 months and liabilities of CN¥48.4m due beyond that. Offsetting these obligations, it had cash of CN¥998.4m as well as receivables valued at CN¥1.16b due within 12 months. So it can boast CN¥1.38b more liquid assets than total liabilities.

This excess liquidity suggests that Weihai Honglin Electronic is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Weihai Honglin Electronic has more cash than debt is arguably a good indication that it can manage its debt safely.

Weihai Honglin Electronic's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Weihai Honglin Electronic 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Weihai Honglin Electronic 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. During the last three years, Weihai Honglin Electronic burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Weihai Honglin Electronic has net cash of CN¥956.9m, as well as more liquid assets than liabilities. So we don't have any problem with Weihai Honglin Electronic'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. Be aware that Weihai Honglin Electronic is showing 2 warning signs in our investment analysis , and 1 of those is significant...

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.