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.' 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. As with many other companies Wafer Works (Shanghai) Co., Ltd. (SHSE:688584) makes use of debt. But the real question is whether this debt is making the company risky.

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Wafer Works (Shanghai)'s Net Debt?

You can click the graphic below for the historical numbers, but it shows that Wafer Works (Shanghai) had CN¥510.0m of debt in March 2024, down from CN¥801.1m, one year before. However, it does have CN¥1.72b in cash offsetting this, leading to net cash of CN¥1.21b.

A Look At Wafer Works (Shanghai)'s Liabilities

The latest balance sheet data shows that Wafer Works (Shanghai) had liabilities of CN¥540.2m due within a year, and liabilities of CN¥221.9m falling due after that. On the other hand, it had cash of CN¥1.72b and CN¥235.1m worth of receivables due within a year. So it actually has CN¥1.20b more liquid assets than total liabilities.

This short term liquidity is a sign that Wafer Works (Shanghai) could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Wafer Works (Shanghai) boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Wafer Works (Shanghai)'s load is not too heavy, because its EBIT was down 54% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Wafer Works (Shanghai) will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Wafer Works (Shanghai) 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, Wafer Works (Shanghai) produced sturdy free cash flow equating to 75% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Wafer Works (Shanghai) has net cash of CN¥1.21b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥156m, being 75% of its EBIT. So we don't have any problem with Wafer Works (Shanghai)'s use of debt. 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. Be aware that Wafer Works (Shanghai) is showing 2 warning signs in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.