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.' 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. We can see that Mesnac Co., Ltd. (SZSE:002073) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is Mesnac's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Mesnac had CN¥2.27b of debt, an increase on CN¥1.74b, over one year. But on the other hand it also has CN¥4.20b in cash, leading to a CN¥1.94b net cash position.

How Strong Is Mesnac's Balance Sheet?

We can see from the most recent balance sheet that Mesnac had liabilities of CN¥9.85b falling due within a year, and liabilities of CN¥1.15b due beyond that. Offsetting these obligations, it had cash of CN¥4.20b as well as receivables valued at CN¥2.17b due within 12 months. So it has liabilities totalling CN¥4.63b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥7.52b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. While it does have liabilities worth noting, Mesnac also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that Mesnac has boosted its EBIT by 46%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is Mesnac's earnings that will influence how the balance sheet holds up in the future. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Mesnac 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 last three years, Mesnac saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While Mesnac does have more liabilities than liquid assets, it also has net cash of CN¥1.94b. And it impressed us with its EBIT growth of 46% over the last year. So we are not troubled with Mesnac's debt use. 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. We've identified 2 warning signs with Mesnac , and understanding them should be part of your investment process.

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.