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.' 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. We can see that Xiamen Zhongchuang Environmental Technology Co., Ltd (SZSE:300056) does use debt in its business. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Xiamen Zhongchuang Environmental Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that Xiamen Zhongchuang Environmental Technology had CN¥207.7m of debt in September 2024, down from CN¥287.1m, one year before. However, it also had CN¥30.7m in cash, and so its net debt is CN¥176.9m.

A Look At Xiamen Zhongchuang Environmental Technology's Liabilities

The latest balance sheet data shows that Xiamen Zhongchuang Environmental Technology had liabilities of CN¥648.2m due within a year, and liabilities of CN¥76.8m falling due after that. Offsetting this, it had CN¥30.7m in cash and CN¥280.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥413.6m.

Given Xiamen Zhongchuang Environmental Technology has a market capitalization of CN¥6.33b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xiamen Zhongchuang Environmental Technology 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.

Over 12 months, Xiamen Zhongchuang Environmental Technology made a loss at the EBIT level, and saw its revenue drop to CN¥456m, which is a fall of 20%. That makes us nervous, to say the least.

Caveat Emptor

Not only did Xiamen Zhongchuang Environmental Technology's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at CN¥116m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled CN¥169m in negative free cash flow over the last twelve months. So suffice it to say we do consider the stock to be risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Xiamen Zhongchuang Environmental Technology .

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.