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. We can see that Wafer Works (Shanghai) Co., Ltd. (SHSE:688584) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 Wafer Works (Shanghai)'s Debt?

As you can see below, Wafer Works (Shanghai) had CN¥186.2m of debt at September 2024, down from CN¥603.2m a year prior. However, its balance sheet shows it holds CN¥1.32b in cash, so it actually has CN¥1.13b net cash.

A Look At Wafer Works (Shanghai)'s Liabilities

Zooming in on the latest balance sheet data, we can see that Wafer Works (Shanghai) had liabilities of CN¥324.5m due within 12 months and liabilities of CN¥132.6m due beyond that. On the other hand, it had cash of CN¥1.32b and CN¥245.5m worth of receivables due within a year. So it actually has CN¥1.11b more liquid assets than total liabilities.

This short term liquidity is a sign that Wafer Works (Shanghai) could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Wafer Works (Shanghai) has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Wafer Works (Shanghai)'s saving grace is its low debt levels, because its EBIT has tanked 71% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Wafer Works (Shanghai) 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. While Wafer Works (Shanghai) 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 last three years, Wafer Works (Shanghai) recorded free cash flow worth a fulsome 91% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Wafer Works (Shanghai) has net cash of CN¥1.13b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥121m, being 91% of its EBIT. So we are not troubled with Wafer Works (Shanghai)'s debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example Wafer Works (Shanghai) has 4 warning signs (and 2 which are concerning) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.