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. As with many other companies Shanghai Chlor-Alkali Chemical Co., Ltd. (SHSE:600618) makes use of debt. But is this debt a concern to shareholders?

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 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Shanghai Chlor-Alkali Chemical Carry?

As you can see below, Shanghai Chlor-Alkali Chemical had CN¥649.3m of debt at September 2024, down from CN¥1.54b a year prior. However, it does have CN¥2.42b in cash offsetting this, leading to net cash of CN¥1.78b.

A Look At Shanghai Chlor-Alkali Chemical's Liabilities

We can see from the most recent balance sheet that Shanghai Chlor-Alkali Chemical had liabilities of CN¥2.66b falling due within a year, and liabilities of CN¥212.0m due beyond that. Offsetting this, it had CN¥2.42b in cash and CN¥623.9m in receivables that were due within 12 months. So it can boast CN¥181.3m more liquid assets than total liabilities.

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

Also positive, Shanghai Chlor-Alkali Chemical grew its EBIT by 20% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shanghai Chlor-Alkali Chemical will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Shanghai Chlor-Alkali Chemical 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. In the last three years, Shanghai Chlor-Alkali Chemical created free cash flow amounting to 7.5% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shanghai Chlor-Alkali Chemical has net cash of CN¥1.78b, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 20% over the last year. So we don't have any problem with Shanghai Chlor-Alkali Chemical's use of debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Shanghai Chlor-Alkali Chemical you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.