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, Shenzhen Gongjin Electronics Co., Ltd. (SHSE:603118) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Shenzhen Gongjin Electronics's Net Debt?

The image below, which you can click on for greater detail, shows that Shenzhen Gongjin Electronics had debt of CN¥881.9m at the end of June 2024, a reduction from CN¥1.69b over a year. However, it does have CN¥2.01b in cash offsetting this, leading to net cash of CN¥1.13b.

How Strong Is Shenzhen Gongjin Electronics' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Gongjin Electronics had liabilities of CN¥3.59b due within 12 months and liabilities of CN¥167.0m due beyond that. On the other hand, it had cash of CN¥2.01b and CN¥1.89b worth of receivables due within a year. So it can boast CN¥146.8m more liquid assets than total liabilities.

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

In fact Shenzhen Gongjin Electronics's saving grace is its low debt levels, because its EBIT has tanked 93% in the last twelve months. 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 Shenzhen Gongjin Electronics 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shenzhen Gongjin Electronics 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, Shenzhen Gongjin Electronics's free cash flow amounted to 45% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shenzhen Gongjin Electronics has CN¥1.13b in net cash and a decent-looking balance sheet. So we don't have any problem with Shenzhen Gongjin Electronics'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. Be aware that Shenzhen Gongjin Electronics is showing 3 warning signs in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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.