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.' 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. Importantly, CRRC Corporation Limited (SHSE:601766) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for CRRC

What Is CRRC's Net Debt?

The image below, which you can click on for greater detail, shows that CRRC had debt of CN¥37.8b at the end of June 2022, a reduction from CN¥45.0b over a year. However, it does have CN¥62.2b in cash offsetting this, leading to net cash of CN¥24.5b.

How Strong Is CRRC's Balance Sheet?

According to the last reported balance sheet, CRRC had liabilities of CN¥244.1b due within 12 months, and liabilities of CN¥22.1b due beyond 12 months. Offsetting these obligations, it had cash of CN¥62.2b as well as receivables valued at CN¥152.3b due within 12 months. So it has liabilities totalling CN¥51.6b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since CRRC has a huge market capitalization of CN¥132.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, CRRC boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact CRRC's saving grace is its low debt levels, because its EBIT has tanked 34% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 CRRC'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. While CRRC 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, CRRC recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

Although CRRC'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¥24.5b. And it impressed us with free cash flow of CN¥25b, being 95% of its EBIT. So we are not troubled with CRRC'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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for CRRC you should know about.

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.