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. We can see that Qingdao Sentury Tire Co., Ltd. (SZSE:002984) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 step when considering a company's debt levels is to consider its cash and debt together.

What Is Qingdao Sentury Tire's Net Debt?

As you can see below, at the end of June 2024, Qingdao Sentury Tire had CN¥2.01b of debt, up from CN¥1.93b a year ago. Click the image for more detail. However, it does have CN¥4.89b in cash offsetting this, leading to net cash of CN¥2.88b.

A Look At Qingdao Sentury Tire's Liabilities

According to the last reported balance sheet, Qingdao Sentury Tire had liabilities of CN¥1.52b due within 12 months, and liabilities of CN¥2.13b due beyond 12 months. Offsetting these obligations, it had cash of CN¥4.89b as well as receivables valued at CN¥1.18b due within 12 months. So it actually has CN¥2.43b more liquid assets than total liabilities.

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

Better yet, Qingdao Sentury Tire grew its EBIT by 117% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Qingdao Sentury Tire'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. Qingdao Sentury Tire 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. Over the last three years, Qingdao Sentury Tire reported free cash flow worth 14% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Qingdao Sentury Tire has net cash of CN¥2.88b, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 117% over the last year. So is Qingdao Sentury Tire's debt a risk? It doesn't seem so to us. 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. For instance, we've identified 1 warning sign for Qingdao Sentury Tire that you should be aware of.

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.

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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.