Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that Shenzhen Gongjin Electronics Co., Ltd. (SHSE:603118) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Shenzhen Gongjin Electronics Carry?

As you can see below, Shenzhen Gongjin Electronics had CN¥1.60b of debt at September 2023, down from CN¥2.45b a year prior. But it also has CN¥2.39b in cash to offset that, meaning it has CN¥789.9m net cash.

How Healthy Is Shenzhen Gongjin Electronics' Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Gongjin Electronics had liabilities of CN¥4.98b falling due within a year, and liabilities of CN¥411.1m due beyond that. Offsetting this, it had CN¥2.39b in cash and CN¥2.50b in receivables that were due within 12 months. So it has liabilities totalling CN¥496.6m more than its cash and near-term receivables, combined.

Given Shenzhen Gongjin Electronics has a market capitalization of CN¥5.66b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Shenzhen Gongjin Electronics also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact Shenzhen Gongjin Electronics's saving grace is its low debt levels, because its EBIT has tanked 24% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shenzhen Gongjin Electronics can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Shenzhen Gongjin Electronics 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. Over the last three years, Shenzhen Gongjin Electronics recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Shenzhen Gongjin Electronics has CN¥789.9m in net cash. So although we see some areas for improvement, we're not too worried about Shenzhen Gongjin Electronics's balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Shenzhen Gongjin Electronics you should be aware of, and 1 of them is significant.

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.