Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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, Guoguang Electric Company Limited (SZSE:002045) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Guoguang Electric's Net Debt?

As you can see below, at the end of June 2024, Guoguang Electric had CN¥2.55b of debt, up from CN¥1.32b a year ago. Click the image for more detail. But on the other hand it also has CN¥3.06b in cash, leading to a CN¥511.7m net cash position.

How Healthy Is Guoguang Electric's Balance Sheet?

The latest balance sheet data shows that Guoguang Electric had liabilities of CN¥4.41b due within a year, and liabilities of CN¥197.7m falling due after that. Offsetting this, it had CN¥3.06b in cash and CN¥1.69b in receivables that were due within 12 months. So it can boast CN¥143.0m more liquid assets than total liabilities.

This short term liquidity is a sign that Guoguang Electric could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Guoguang Electric has more cash than debt is arguably a good indication that it can manage its debt safely.

On top of that, Guoguang Electric grew its EBIT by 52% 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 future earnings, more than anything, that will determine Guoguang Electric's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Guoguang Electric 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. Over the last two years, Guoguang Electric actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While it is always sensible to investigate a company's debt, in this case Guoguang Electric has CN¥511.7m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 153% of that EBIT to free cash flow, bringing in CN¥61m. So is Guoguang Electric's debt a risk? It doesn't seem so to us. 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 Guoguang Electric , and understanding them should be part of your investment process.

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.