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 Jilin Aodong Pharmaceutical Group Co., Ltd. (SZSE:000623) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Jilin Aodong Pharmaceutical Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Jilin Aodong Pharmaceutical Group had CN¥3.16b of debt, an increase on CN¥2.95b, over one year. But it also has CN¥3.62b in cash to offset that, meaning it has CN¥458.9m net cash.

A Look At Jilin Aodong Pharmaceutical Group's Liabilities

The latest balance sheet data shows that Jilin Aodong Pharmaceutical Group had liabilities of CN¥4.52b due within a year, and liabilities of CN¥308.5m falling due after that. Offsetting this, it had CN¥3.62b in cash and CN¥1.57b in receivables that were due within 12 months. So it can boast CN¥361.9m more liquid assets than total liabilities.

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

While Jilin Aodong Pharmaceutical Group doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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 Jilin Aodong Pharmaceutical Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Jilin Aodong Pharmaceutical Group 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 two years, Jilin Aodong Pharmaceutical Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Jilin Aodong Pharmaceutical Group has net cash of CN¥458.9m, as well as more liquid assets than liabilities. So we don't have any problem with Jilin Aodong Pharmaceutical Group's use of debt. 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. To that end, you should be aware of the 2 warning signs we've spotted with Jilin Aodong Pharmaceutical Group .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.