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.' 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. Importantly, Shanghai Datun Energy Resources Co., Ltd. (SHSE:600508) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Shanghai Datun Energy Resources Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Shanghai Datun Energy Resources had CN¥1.40b of debt, an increase on CN¥1.11b, over one year. However, it does have CN¥3.01b in cash offsetting this, leading to net cash of CN¥1.61b.

How Healthy Is Shanghai Datun Energy Resources' Balance Sheet?

According to the last reported balance sheet, Shanghai Datun Energy Resources had liabilities of CN¥3.13b due within 12 months, and liabilities of CN¥3.75b due beyond 12 months. Offsetting this, it had CN¥3.01b in cash and CN¥668.3m in receivables that were due within 12 months. So it has liabilities totalling CN¥3.20b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Shanghai Datun Energy Resources is worth CN¥8.19b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Shanghai Datun Energy Resources also has more cash than debt, so we're pretty confident it can manage its debt safely.

It is just as well that Shanghai Datun Energy Resources's load is not too heavy, because its EBIT was down 78% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shanghai Datun Energy Resources's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Shanghai Datun Energy Resources 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. During the last three years, Shanghai Datun Energy Resources produced sturdy free cash flow equating to 60% 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

Although Shanghai Datun Energy Resources's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥1.61b. So we are not troubled with Shanghai Datun Energy Resources's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Shanghai Datun Energy Resources that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.