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 Chongqing Changan Automobile Company Limited (SZSE:000625) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Chongqing Changan Automobile's Net Debt?

As you can see below, at the end of March 2024, Chongqing Changan Automobile had CN¥1.21b of debt, up from CN¥1.13b a year ago. Click the image for more detail. But it also has CN¥70.2b in cash to offset that, meaning it has CN¥69.0b net cash.

A Look At Chongqing Changan Automobile's Liabilities

Zooming in on the latest balance sheet data, we can see that Chongqing Changan Automobile had liabilities of CN¥101.9b due within 12 months and liabilities of CN¥12.9b due beyond that. Offsetting this, it had CN¥70.2b in cash and CN¥38.5b in receivables that were due within 12 months. So it has liabilities totalling CN¥6.09b more than its cash and near-term receivables, combined.

Since publicly traded Chongqing Changan Automobile shares are worth a very impressive total of CN¥127.7b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Chongqing Changan Automobile also has more cash than debt, so we're pretty confident it can manage its debt safely.

Importantly, Chongqing Changan Automobile's EBIT fell a jaw-dropping 63% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Chongqing Changan Automobile'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Chongqing Changan Automobile 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. Happily for any shareholders, Chongqing Changan Automobile actually produced more free cash flow than EBIT over the last three years. 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 it is always sensible to look at a company's total liabilities, it is very reassuring that Chongqing Changan Automobile has CN¥69.0b in net cash. And it impressed us with free cash flow of CN¥19b, being 317% of its EBIT. So we don't have any problem with Chongqing Changan Automobile's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Chongqing Changan Automobile , and understanding them should be part of your investment process.

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.