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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Shanghai Chlor-Alkali Chemical Co., Ltd. (SHSE:600618) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

How Much Debt Does Shanghai Chlor-Alkali Chemical Carry?

As you can see below, Shanghai Chlor-Alkali Chemical had CN¥621.0m of debt at June 2024, down from CN¥1.78b a year prior. But it also has CN¥1.95b in cash to offset that, meaning it has CN¥1.33b net cash.

How Healthy Is Shanghai Chlor-Alkali Chemical's Balance Sheet?

We can see from the most recent balance sheet that Shanghai Chlor-Alkali Chemical had liabilities of CN¥2.07b falling due within a year, and liabilities of CN¥211.6m due beyond that. Offsetting this, it had CN¥1.95b in cash and CN¥392.9m in receivables that were due within 12 months. So it can boast CN¥64.1m more liquid assets than total liabilities.

Having regard to Shanghai Chlor-Alkali Chemical's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥7.34b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Shanghai Chlor-Alkali Chemical has more cash than debt is arguably a good indication that it can manage its debt safely.

And we also note warmly that Shanghai Chlor-Alkali Chemical grew its EBIT by 13% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shanghai Chlor-Alkali 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shanghai Chlor-Alkali Chemical 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. In the last three years, Shanghai Chlor-Alkali Chemical created free cash flow amounting to 3.4% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shanghai Chlor-Alkali Chemical has CN¥1.33b in net cash and a decent-looking balance sheet. And it also grew its EBIT by 13% over the last year. So we are not troubled with Shanghai Chlor-Alkali 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. To that end, you should be aware of the 1 warning sign we've spotted with Shanghai Chlor-Alkali Chemical .

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.

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