Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Guangdong Shirongzhaoye Co., Ltd. (SZSE:002016) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Guangdong Shirongzhaoye's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Guangdong Shirongzhaoye had CN¥90.0m of debt, an increase on none, over one year. But it also has CN¥277.3m in cash to offset that, meaning it has CN¥187.3m net cash.

How Strong Is Guangdong Shirongzhaoye's Balance Sheet?

We can see from the most recent balance sheet that Guangdong Shirongzhaoye had liabilities of CN¥1.24b falling due within a year, and liabilities of CN¥58.4m due beyond that. Offsetting this, it had CN¥277.3m in cash and CN¥468.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥554.4m.

Since publicly traded Guangdong Shirongzhaoye shares are worth a total of CN¥4.58b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Guangdong Shirongzhaoye boasts net cash, so it's fair to say it does not have a heavy debt load!

On top of that, Guangdong Shirongzhaoye grew its EBIT by 30% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Guangdong Shirongzhaoye'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Guangdong Shirongzhaoye 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, Guangdong Shirongzhaoye 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 Guangdong Shirongzhaoye does have more liabilities than liquid assets, it also has net cash of CN¥187.3m. And we liked the look of last year's 30% year-on-year EBIT growth. So we are not troubled with Guangdong Shirongzhaoye's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Guangdong Shirongzhaoye (at least 2 which are significant) , 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com