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. As with many other companies Chengxin Lithium Group Co., Ltd. (SZSE:002240) makes use of debt. But should shareholders be worried about its use of debt?

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. 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. 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.

How Much Debt Does Chengxin Lithium Group Carry?

As you can see below, at the end of September 2024, Chengxin Lithium Group had CN¥6.70b of debt, up from CN¥6.16b a year ago. Click the image for more detail. However, it does have CN¥1.73b in cash offsetting this, leading to net debt of about CN¥4.97b.

How Healthy Is Chengxin Lithium Group's Balance Sheet?

We can see from the most recent balance sheet that Chengxin Lithium Group had liabilities of CN¥6.88b falling due within a year, and liabilities of CN¥1.97b due beyond that. On the other hand, it had cash of CN¥1.73b and CN¥694.4m worth of receivables due within a year. So its liabilities total CN¥6.43b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Chengxin Lithium Group is worth CN¥12.9b, and thus could probably raise enough capital to shore up 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Chengxin Lithium 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.

In the last year Chengxin Lithium Group had a loss before interest and tax, and actually shrunk its revenue by 54%, to CN¥4.8b. To be frank that doesn't bode well.

Caveat Emptor

Not only did Chengxin Lithium Group's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost CN¥725m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled CN¥1.7b in negative free cash flow over the last twelve months. So in short it's a really risky stock. 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. To that end, you should learn about the 2 warning signs we've spotted with Chengxin Lithium Group (including 1 which is potentially serious) .

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.