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 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 Sanxiang Advanced Materials Co., Ltd. (SHSE:603663) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Sanxiang Advanced Materials

What Is Sanxiang Advanced Materials's Debt?

As you can see below, Sanxiang Advanced Materials had CN¥182.0m of debt at June 2022, down from CN¥438.3m a year prior. But on the other hand it also has CN¥198.0m in cash, leading to a CN¥16.1m net cash position.

How Healthy Is Sanxiang Advanced Materials' Balance Sheet?

We can see from the most recent balance sheet that Sanxiang Advanced Materials had liabilities of CN¥381.7m falling due within a year, and liabilities of CN¥91.7m due beyond that. On the other hand, it had cash of CN¥198.0m and CN¥252.2m worth of receivables due within a year. So it has liabilities totalling CN¥23.2m more than its cash and near-term receivables, combined.

This state of affairs indicates that Sanxiang Advanced Materials' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CN¥4.78b company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, Sanxiang Advanced Materials also has more cash than debt, so we're pretty confident it can manage its debt safely.

On top of that, Sanxiang Advanced Materials grew its EBIT by 47% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Sanxiang Advanced Materials's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Sanxiang Advanced Materials 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. In the last three years, Sanxiang Advanced Materials created free cash flow amounting to 7.8% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

We could understand if investors are concerned about Sanxiang Advanced Materials's liabilities, but we can be reassured by the fact it has has net cash of CN¥16.1m. And we liked the look of last year's 47% year-on-year EBIT growth. So is Sanxiang Advanced Materials's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Sanxiang Advanced Materials (1 is significant!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.