Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Shanghai Moons' Electric Co., Ltd. (SHSE:603728) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Shanghai Moons' Electric's Debt?

As you can see below, at the end of September 2024, Shanghai Moons' Electric had CN¥375.7m of debt, up from CN¥219.0m a year ago. Click the image for more detail. But it also has CN¥770.4m in cash to offset that, meaning it has CN¥394.7m net cash.

A Look At Shanghai Moons' Electric's Liabilities

According to the last reported balance sheet, Shanghai Moons' Electric had liabilities of CN¥976.0m due within 12 months, and liabilities of CN¥107.7m due beyond 12 months. Offsetting this, it had CN¥770.4m in cash and CN¥814.8m in receivables that were due within 12 months. So it actually has CN¥501.5m more liquid assets than total liabilities.

This surplus suggests that Shanghai Moons' Electric has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Shanghai Moons' Electric boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Shanghai Moons' Electric's saving grace is its low debt levels, because its EBIT has tanked 55% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shanghai Moons' Electric can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Shanghai Moons' Electric 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. Considering the last three years, Shanghai Moons' Electric actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shanghai Moons' Electric has net cash of CN¥394.7m, as well as more liquid assets than liabilities. So although we see some areas for improvement, we're not too worried about Shanghai Moons' Electric's balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Shanghai Moons' Electric 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.