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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Shandong Haihua Co.,Ltd (SZSE:000822) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shandong HaihuaLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Shandong HaihuaLtd had CN¥252.6m of debt, an increase on CN¥141.1m, over one year. But on the other hand it also has CN¥1.82b in cash, leading to a CN¥1.57b net cash position.

How Strong Is Shandong HaihuaLtd's Balance Sheet?

We can see from the most recent balance sheet that Shandong HaihuaLtd had liabilities of CN¥2.58b falling due within a year, and liabilities of CN¥612.0m due beyond that. Offsetting these obligations, it had cash of CN¥1.82b as well as receivables valued at CN¥2.41b due within 12 months. So it can boast CN¥1.04b more liquid assets than total liabilities.

This excess liquidity suggests that Shandong HaihuaLtd is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Shandong HaihuaLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

On the other hand, Shandong HaihuaLtd's EBIT dived 13%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But it is Shandong HaihuaLtd's earnings that will influence how the balance sheet holds up in the future. 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. While Shandong HaihuaLtd 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. Over the most recent three years, Shandong HaihuaLtd recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shandong HaihuaLtd has CN¥1.57b in net cash and a decent-looking balance sheet. So we don't have any problem with Shandong HaihuaLtd's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Shandong HaihuaLtd 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.