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 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. We can see that Dirui Industrial Co.,Ltd. (SZSE:300396) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Dirui IndustrialLtd

How Much Debt Does Dirui IndustrialLtd Carry?

As you can see below, at the end of September 2023, Dirui IndustrialLtd had CN¥342.8m of debt, up from CN¥293.0m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥849.0m in cash, so it actually has CN¥506.2m net cash.

How Strong Is Dirui IndustrialLtd's Balance Sheet?

The latest balance sheet data shows that Dirui IndustrialLtd had liabilities of CN¥926.3m due within a year, and liabilities of CN¥100.1m falling due after that. Offsetting these obligations, it had cash of CN¥849.0m as well as receivables valued at CN¥332.0m due within 12 months. So it actually has CN¥154.6m more liquid assets than total liabilities.

This short term liquidity is a sign that Dirui IndustrialLtd could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Dirui IndustrialLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

In addition to that, we're happy to report that Dirui IndustrialLtd has boosted its EBIT by 38%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Dirui IndustrialLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Dirui IndustrialLtd 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. Looking at the most recent three years, Dirui IndustrialLtd recorded free cash flow of 44% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While it is always sensible to investigate a company's debt, in this case Dirui IndustrialLtd has CN¥506.2m in net cash and a decent-looking balance sheet. And we liked the look of last year's 38% year-on-year EBIT growth. So we don't think Dirui IndustrialLtd's use of debt is risky. 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 2 warning signs for Dirui IndustrialLtd 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.