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.' 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. We note that Shanghai Stonehill Technology Co., Ltd. (SZSE:002195) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Shanghai Stonehill Technology's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Shanghai Stonehill Technology had CN¥47.0m of debt in September 2023, down from CN¥208.4m, one year before. However, its balance sheet shows it holds CN¥7.25b in cash, so it actually has CN¥7.21b net cash.
A Look At Shanghai Stonehill Technology's Liabilities
According to the last reported balance sheet, Shanghai Stonehill Technology had liabilities of CN¥262.9m due within 12 months, and liabilities of CN¥43.5m due beyond 12 months. Offsetting this, it had CN¥7.25b in cash and CN¥341.4m in receivables that were due within 12 months. So it actually has CN¥7.29b more liquid assets than total liabilities.
This surplus liquidity suggests that Shanghai Stonehill Technology's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Shanghai Stonehill Technology has more cash than debt is arguably a good indication that it can manage its debt safely.
It is just as well that Shanghai Stonehill Technology's load is not too heavy, because its EBIT was down 86% over the last year. 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 it is Shanghai Stonehill Technology'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shanghai Stonehill Technology 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. Over the last three years, Shanghai Stonehill Technology actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Summing Up
While it is always sensible to investigate a company's debt, in this case Shanghai Stonehill Technology has CN¥7.21b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥313m, being 205% of its EBIT. So we don't think Shanghai Stonehill Technology's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Shanghai Stonehill Technology has 4 warning signs (and 1 which is a bit unpleasant) we think you should know about.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.