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. As with many other companies Shenzhen Deren Electronic Co., Ltd. (SZSE:002055) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Shenzhen Deren Electronic

What Is Shenzhen Deren Electronic's Debt?

The image below, which you can click on for greater detail, shows that Shenzhen Deren Electronic had debt of CN¥797.1m at the end of June 2023, a reduction from CN¥915.7m over a year. However, it also had CN¥692.1m in cash, and so its net debt is CN¥105.0m.

A Look At Shenzhen Deren Electronic's Liabilities

According to the last reported balance sheet, Shenzhen Deren Electronic had liabilities of CN¥3.10b due within 12 months, and liabilities of CN¥1.87b due beyond 12 months. Offsetting this, it had CN¥692.1m in cash and CN¥2.27b in receivables that were due within 12 months. So its liabilities total CN¥2.00b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Shenzhen Deren Electronic has a market capitalization of CN¥5.50b, 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. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shenzhen Deren Electronic 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.

Over 12 months, Shenzhen Deren Electronic saw its revenue hold pretty steady, and it did not report positive earnings before interest and tax. While that's not too bad, we'd prefer see growth.

Caveat Emptor

Importantly, Shenzhen Deren Electronic had an earnings before interest and tax (EBIT) loss over the last year. To be specific the EBIT loss came in at CN¥190m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled CN¥766m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very 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. We've identified 2 warning signs with Shenzhen Deren Electronic , 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.