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. As with many other companies Shenzhen SEG Co.,Ltd (SZSE:000058) makes use of debt. But the real question is whether this debt is making the company risky.

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Shenzhen SEGLtd's Net Debt?

As you can see below, Shenzhen SEGLtd had CN¥842.0m of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds CN¥1.22b in cash, so it actually has CN¥375.3m net cash.

How Strong Is Shenzhen SEGLtd's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen SEGLtd had liabilities of CN¥2.10b falling due within a year, and liabilities of CN¥723.4m due beyond that. On the other hand, it had cash of CN¥1.22b and CN¥453.2m worth of receivables due within a year. So it has liabilities totalling CN¥1.15b more than its cash and near-term receivables, combined.

Of course, Shenzhen SEGLtd has a market capitalization of CN¥6.06b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Shenzhen SEGLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Shenzhen SEGLtd if management cannot prevent a repeat of the 77% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shenzhen SEGLtd will need earnings to service that debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shenzhen SEGLtd 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. Happily for any shareholders, Shenzhen SEGLtd actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

Although Shenzhen SEGLtd'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¥375.3m. And it impressed us with free cash flow of CN¥346m, being 375% of its EBIT. So we don't have any problem with Shenzhen SEGLtd's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Shenzhen SEGLtd you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.