David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Shanghai Material Trading Co., Ltd. (SHSE:600822) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shanghai Material Trading's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Shanghai Material Trading had CN¥145.2m of debt, an increase on CN¥62.5m, over one year. But it also has CN¥1.15b in cash to offset that, meaning it has CN¥1.00b net cash.

How Healthy Is Shanghai Material Trading's Balance Sheet?

The latest balance sheet data shows that Shanghai Material Trading had liabilities of CN¥1.47b due within a year, and liabilities of CN¥234.6m falling due after that. Offsetting these obligations, it had cash of CN¥1.15b as well as receivables valued at CN¥213.4m due within 12 months. So it has liabilities totalling CN¥344.8m more than its cash and near-term receivables, combined.

Given Shanghai Material Trading has a market capitalization of CN¥3.65b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Shanghai Material Trading also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Shanghai Material Trading if management cannot prevent a repeat of the 65% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shanghai Material Trading 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Shanghai Material Trading 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, Shanghai Material Trading actually produced more free cash flow than EBIT over the last two 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

While it is always sensible to look at a company's total liabilities, it is very reassuring that Shanghai Material Trading has CN¥1.00b in net cash. And it impressed us with free cash flow of CN¥341m, being 1,463% of its EBIT. So we are not troubled with Shanghai Material Trading's debt use. 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. Be aware that Shanghai Material Trading is showing 2 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.

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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.