Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that China Railway Signal & Communication Corporation Limited (HKG:3969) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for China Railway Signal & Communication

What Is China Railway Signal & Communication's Debt?

The image below, which you can click on for greater detail, shows that at March 2022 China Railway Signal & Communication had debt of CN¥3.79b, up from CN¥2.85b in one year. However, its balance sheet shows it holds CN¥21.7b in cash, so it actually has CN¥18.0b net cash.

How Strong Is China Railway Signal & Communication's Balance Sheet?

We can see from the most recent balance sheet that China Railway Signal & Communication had liabilities of CN¥58.3b falling due within a year, and liabilities of CN¥4.50b due beyond that. Offsetting this, it had CN¥21.7b in cash and CN¥61.1b in receivables that were due within 12 months. So it actually has CN¥20.1b more liquid assets than total liabilities.

This excess liquidity is a great indication that China Railway Signal & Communication's balance sheet is almost as strong as Fort Knox. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, China Railway Signal & Communication boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that China Railway Signal & Communication has seen its EBIT plunge 16% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Railway Signal & Communication'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, a company can only pay off debt with cold hard cash, not accounting profits. While China Railway Signal & Communication 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, China Railway Signal & Communication's free cash flow amounted to 47% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that China Railway Signal & Communication has net cash of CN¥18.0b, as well as more liquid assets than liabilities. So we are not troubled with China Railway Signal & Communication's debt use. 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 1 warning sign with China Railway Signal & Communication , 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.