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, Jiangsu Huachang Chemical Co., Ltd (SZSE:002274) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Jiangsu Huachang Chemical's Net Debt?

The image below, which you can click on for greater detail, shows that Jiangsu Huachang Chemical had debt of CN¥268.6m at the end of March 2024, a reduction from CN¥660.9m over a year. But it also has CN¥783.8m in cash to offset that, meaning it has CN¥515.1m net cash.

How Healthy Is Jiangsu Huachang Chemical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Jiangsu Huachang Chemical had liabilities of CN¥2.53b due within 12 months and liabilities of CN¥7.40m due beyond that. Offsetting this, it had CN¥783.8m in cash and CN¥1.35b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥401.9m.

Given Jiangsu Huachang Chemical has a market capitalization of CN¥7.79b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Jiangsu Huachang Chemical also has more cash than debt, so we're pretty confident it can manage its debt safely.

On the other hand, Jiangsu Huachang Chemical's EBIT dived 10%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Jiangsu Huachang Chemical's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Jiangsu Huachang Chemical 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. Over the most recent three years, Jiangsu Huachang Chemical recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

We could understand if investors are concerned about Jiangsu Huachang Chemical's liabilities, but we can be reassured by the fact it has has net cash of CN¥515.1m. The cherry on top was that in converted 72% of that EBIT to free cash flow, bringing in CN¥556m. So we are not troubled with Jiangsu Huachang Chemical's debt use. 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 Jiangsu Huachang Chemical is showing 1 warning sign in our investment analysis , you should know about...

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.