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 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. As with many other companies Changgao Electric Group Co., Ltd. (SZSE:002452) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Changgao Electric Group

What Is Changgao Electric Group's Debt?

The image below, which you can click on for greater detail, shows that Changgao Electric Group had debt of CN¥86.3m at the end of March 2022, a reduction from CN¥837.8m over a year. However, its balance sheet shows it holds CN¥653.3m in cash, so it actually has CN¥567.0m net cash.

A Look At Changgao Electric Group's Liabilities

We can see from the most recent balance sheet that Changgao Electric Group had liabilities of CN¥830.5m falling due within a year, and liabilities of CN¥220.1m due beyond that. On the other hand, it had cash of CN¥653.3m and CN¥1.22b worth of receivables due within a year. So it actually has CN¥820.2m more liquid assets than total liabilities.

It's good to see that Changgao Electric Group has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Changgao Electric Group has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Changgao Electric Group's saving grace is its low debt levels, because its EBIT has tanked 36% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Changgao Electric Group will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Changgao Electric Group 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, Changgao Electric Group saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Changgao Electric Group has net cash of CN¥567.0m, as well as more liquid assets than liabilities. So we are not troubled with Changgao Electric Group's debt use. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Changgao Electric Group that you should be aware of.

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.