The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We note that Unilumin Group Co., Ltd (SZSE:300232) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Unilumin Group's Net Debt?

The image below, which you can click on for greater detail, shows that Unilumin Group had debt of CN¥655.0m at the end of September 2024, a reduction from CN¥714.3m over a year. But it also has CN¥1.56b in cash to offset that, meaning it has CN¥901.6m net cash.

How Healthy Is Unilumin Group's Balance Sheet?

According to the last reported balance sheet, Unilumin Group had liabilities of CN¥5.47b due within 12 months, and liabilities of CN¥399.6m due beyond 12 months. Offsetting this, it had CN¥1.56b in cash and CN¥2.68b in receivables that were due within 12 months. So its liabilities total CN¥1.64b more than the combination of its cash and short-term receivables.

Unilumin Group has a market capitalization of CN¥7.76b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Unilumin Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, Unilumin Group turned things around in the last 12 months, delivering and EBIT of CN¥227m. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Unilumin Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Unilumin Group 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. During the last year, Unilumin Group produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

Although Unilumin Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥901.6m. And it impressed us with free cash flow of CN¥178m, being 78% of its EBIT. So we don't think Unilumin Group's use of debt is risky. 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. We've identified 2 warning signs with Unilumin Group , and understanding them should be part of your investment process.

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.