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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Shanghai Fortune Techgroup Co., Ltd. (SZSE:300493) makes use of 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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shanghai Fortune Techgroup's Debt?

As you can see below, at the end of September 2024, Shanghai Fortune Techgroup had CN¥150.3m of debt, up from CN¥87.1m a year ago. Click the image for more detail. But it also has CN¥272.6m in cash to offset that, meaning it has CN¥122.3m net cash.

How Strong Is Shanghai Fortune Techgroup's Balance Sheet?

According to the last reported balance sheet, Shanghai Fortune Techgroup had liabilities of CN¥752.2m due within 12 months, and liabilities of CN¥25.9m due beyond 12 months. Offsetting this, it had CN¥272.6m in cash and CN¥951.5m in receivables that were due within 12 months. So it can boast CN¥446.0m more liquid assets than total liabilities.

This surplus suggests that Shanghai Fortune Techgroup has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Shanghai Fortune Techgroup has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Shanghai Fortune Techgroup's load is not too heavy, because its EBIT was down 31% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shanghai Fortune Techgroup's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Shanghai Fortune Techgroup 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. In the last three years, Shanghai Fortune Techgroup created free cash flow amounting to 3.4% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shanghai Fortune Techgroup has CN¥122.3m in net cash and a decent-looking balance sheet. So we don't have any problem with Shanghai Fortune Techgroup's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Shanghai Fortune Techgroup is showing 2 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.