Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Shanghai Lonyer Data Co., Ltd. (SHSE:603003) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shanghai Lonyer Data

What Is Shanghai Lonyer Data's Net Debt?

As you can see below, at the end of September 2023, Shanghai Lonyer Data had CN¥523.7m of debt, up from CN¥142.0m a year ago. Click the image for more detail. However, it does have CN¥998.2m in cash offsetting this, leading to net cash of CN¥474.5m.

How Healthy Is Shanghai Lonyer Data's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Lonyer Data had liabilities of CN¥987.4m due within 12 months and liabilities of CN¥410.4m due beyond that. Offsetting this, it had CN¥998.2m in cash and CN¥684.0m in receivables that were due within 12 months. So it can boast CN¥284.4m more liquid assets than total liabilities.

This short term liquidity is a sign that Shanghai Lonyer Data could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Shanghai Lonyer Data has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Shanghai Lonyer Data's saving grace is its low debt levels, because its EBIT has tanked 56% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shanghai Lonyer Data will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Shanghai Lonyer Data 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. In the last two years, Shanghai Lonyer Data created free cash flow amounting to 17% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shanghai Lonyer Data has CN¥474.5m in net cash and a decent-looking balance sheet. So we are not troubled with Shanghai Lonyer Data's debt use. 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. To that end, you should be aware of the 1 warning sign we've spotted with Shanghai Lonyer Data .

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.