Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Medical System Holdings Limited (HKG:867) does use debt in its business. But the real question is whether this debt is making the company risky.

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. 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. 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 China Medical System Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that China Medical System Holdings had CN¥1.29b of debt in December 2023, down from CN¥1.78b, one year before. However, its balance sheet shows it holds CN¥6.14b in cash, so it actually has CN¥4.86b net cash.

How Healthy Is China Medical System Holdings' Balance Sheet?

The latest balance sheet data shows that China Medical System Holdings had liabilities of CN¥2.05b due within a year, and liabilities of CN¥125.6m falling due after that. Offsetting these obligations, it had cash of CN¥6.14b as well as receivables valued at CN¥1.86b due within 12 months. So it can boast CN¥5.83b more liquid assets than total liabilities.

This luscious liquidity implies that China Medical System Holdings' balance sheet is sturdy like a giant sequoia tree. Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that China Medical System Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact China Medical System Holdings's saving grace is its low debt levels, because its EBIT has tanked 24% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Medical System Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. China Medical System Holdings 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. Over the last three years, China Medical System Holdings recorded free cash flow worth a fulsome 80% 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 China Medical System Holdings has net cash of CN¥4.86b, as well as more liquid assets than liabilities. The cherry on top was that in converted 80% of that EBIT to free cash flow, bringing in CN¥2.2b. So we don't think China Medical System Holdings'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. For example - China Medical System Holdings has 2 warning signs we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.