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.' 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. Importantly, Shijiazhuang Kelin Electric Co., Ltd. (SHSE:603050) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Shijiazhuang Kelin Electric Carry?

As you can see below, Shijiazhuang Kelin Electric had CN¥1.08b of debt at September 2024, down from CN¥1.49b a year prior. However, because it has a cash reserve of CN¥607.1m, its net debt is less, at about CN¥470.3m.

How Strong Is Shijiazhuang Kelin Electric's Balance Sheet?

According to the last reported balance sheet, Shijiazhuang Kelin Electric had liabilities of CN¥2.81b due within 12 months, and liabilities of CN¥714.0m due beyond 12 months. Offsetting these obligations, it had cash of CN¥607.1m as well as receivables valued at CN¥2.36b due within 12 months. So it has liabilities totalling CN¥558.5m more than its cash and near-term receivables, combined.

Since publicly traded Shijiazhuang Kelin Electric shares are worth a total of CN¥6.00b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shijiazhuang Kelin Electric has net debt of just 1.2 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.8 times the interest expense over the last year. On top of that, Shijiazhuang Kelin Electric grew its EBIT by 71% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shijiazhuang Kelin Electric 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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shijiazhuang Kelin Electric recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On our analysis Shijiazhuang Kelin Electric's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. In particular, conversion of EBIT to free cash flow gives us cold feet. Considering this range of data points, we think Shijiazhuang Kelin Electric is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. To that end, you should be aware of the 1 warning sign we've spotted with Shijiazhuang Kelin Electric .

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.