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.' 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. We can see that Shenzhen VAPEL Power Supply Technology Co., Ltd. (SZSE:301516) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Shenzhen VAPEL Power Supply Technology's Net Debt?

As you can see below, Shenzhen VAPEL Power Supply Technology had CN¥64.7m of debt at March 2024, down from CN¥228.1m a year prior. But it also has CN¥296.0m in cash to offset that, meaning it has CN¥231.4m net cash.

How Healthy Is Shenzhen VAPEL Power Supply Technology's Balance Sheet?

According to the last reported balance sheet, Shenzhen VAPEL Power Supply Technology had liabilities of CN¥364.9m due within 12 months, and liabilities of CN¥10.2m due beyond 12 months. Offsetting these obligations, it had cash of CN¥296.0m as well as receivables valued at CN¥282.0m due within 12 months. So it actually has CN¥202.8m more liquid assets than total liabilities.

This surplus suggests that Shenzhen VAPEL Power Supply Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Shenzhen VAPEL Power Supply Technology boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Shenzhen VAPEL Power Supply Technology's load is not too heavy, because its EBIT was down 60% 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 it is Shenzhen VAPEL Power Supply Technology'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shenzhen VAPEL Power Supply Technology 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. During the last three years, Shenzhen VAPEL Power Supply Technology produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shenzhen VAPEL Power Supply Technology has net cash of CN¥231.4m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥114m, being 66% of its EBIT. So we don't have any problem with Shenzhen VAPEL Power Supply Technology's use of debt. 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. Be aware that Shenzhen VAPEL Power Supply Technology is showing 5 warning signs in our investment analysis , and 2 of those don't sit too well with us...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.