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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Shanghai M&G Stationery Inc. (SHSE:603899) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Shanghai M&G Stationery's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2023 Shanghai M&G Stationery had debt of CN¥418.9m, up from CN¥357.9m in one year. But on the other hand it also has CN¥5.49b in cash, leading to a CN¥5.08b net cash position.
How Strong Is Shanghai M&G Stationery's Balance Sheet?
The latest balance sheet data shows that Shanghai M&G Stationery had liabilities of CN¥5.63b due within a year, and liabilities of CN¥379.5m falling due after that. Offsetting this, it had CN¥5.49b in cash and CN¥4.04b in receivables that were due within 12 months. So it actually has CN¥3.52b more liquid assets than total liabilities.
This surplus suggests that Shanghai M&G Stationery has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Shanghai M&G Stationery boasts net cash, so it's fair to say it does not have a heavy debt load!
Shanghai M&G Stationery's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. 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 Shanghai M&G Stationery 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Shanghai M&G Stationery 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. During the last three years, Shanghai M&G Stationery produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Summing Up
While it is always sensible to investigate a company's debt, in this case Shanghai M&G Stationery has CN¥5.08b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥1.6b, being 79% of its EBIT. So is Shanghai M&G Stationery's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Shanghai M&G Stationery that you should be aware of before investing here.
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.