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. We note that Zhejiang Windey Co.,Ltd. (SZSE:300772) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Zhejiang WindeyLtd

What Is Zhejiang WindeyLtd's Debt?

The image below, which you can click on for greater detail, shows that Zhejiang WindeyLtd had debt of CN¥749.9m at the end of March 2022, a reduction from CN¥991.7m over a year. But it also has CN¥4.05b in cash to offset that, meaning it has CN¥3.30b net cash.

A Look At Zhejiang WindeyLtd's Liabilities

We can see from the most recent balance sheet that Zhejiang WindeyLtd had liabilities of CN¥19.3b falling due within a year, and liabilities of CN¥2.48b due beyond that. On the other hand, it had cash of CN¥4.05b and CN¥8.58b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥9.10b.

When you consider that this deficiency exceeds the company's CN¥8.94b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Zhejiang WindeyLtd boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

Better yet, Zhejiang WindeyLtd grew its EBIT by 295% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zhejiang WindeyLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Zhejiang WindeyLtd 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, Zhejiang WindeyLtd recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Summing up

Although Zhejiang WindeyLtd's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥3.30b. And we liked the look of last year's 295% year-on-year EBIT growth. So we are not troubled with Zhejiang WindeyLtd's debt use. 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. To that end, you should be aware of the 3 warning signs we've spotted with Zhejiang WindeyLtd .

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.