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. Importantly, Shanghai Fullhan Microelectronics Co., Ltd. (SZSE:300613) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Shanghai Fullhan Microelectronics Carry?

You can click the graphic below for the historical numbers, but it shows that Shanghai Fullhan Microelectronics had CN¥579.8m of debt in September 2024, down from CN¥637.3m, one year before. But on the other hand it also has CN¥1.76b in cash, leading to a CN¥1.18b net cash position.

How Healthy Is Shanghai Fullhan Microelectronics' Balance Sheet?

According to the last reported balance sheet, Shanghai Fullhan Microelectronics had liabilities of CN¥282.5m due within 12 months, and liabilities of CN¥582.8m due beyond 12 months. On the other hand, it had cash of CN¥1.76b and CN¥472.1m worth of receivables due within a year. So it actually has CN¥1.37b more liquid assets than total liabilities.

This short term liquidity is a sign that Shanghai Fullhan Microelectronics could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Shanghai Fullhan Microelectronics boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Shanghai Fullhan Microelectronics'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 ultimately the future profitability of the business will decide if Shanghai Fullhan Microelectronics can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shanghai Fullhan Microelectronics 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, Shanghai Fullhan Microelectronics actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shanghai Fullhan Microelectronics has net cash of CN¥1.18b, as well as more liquid assets than liabilities. The cherry on top was that in converted 120% of that EBIT to free cash flow, bringing in CN¥300m. So we don't think Shanghai Fullhan Microelectronics's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Shanghai Fullhan Microelectronics that you should be aware of before investing here.

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.