The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that Fujian Yuanli Active Carbon Co.,Ltd. (SZSE:300174) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Fujian Yuanli Active CarbonLtd's Net Debt?

The image below, which you can click on for greater detail, shows that Fujian Yuanli Active CarbonLtd had debt of CN¥364.5m at the end of September 2023, a reduction from CN¥892.7m over a year. But on the other hand it also has CN¥1.49b in cash, leading to a CN¥1.12b net cash position.

How Healthy Is Fujian Yuanli Active CarbonLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Fujian Yuanli Active CarbonLtd had liabilities of CN¥520.4m due within 12 months and liabilities of CN¥121.6m due beyond that. Offsetting these obligations, it had cash of CN¥1.49b as well as receivables valued at CN¥448.0m due within 12 months. So it can boast CN¥1.29b more liquid assets than total liabilities.

This surplus suggests that Fujian Yuanli Active CarbonLtd is using debt in a way that is appears to be both safe and conservative. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Succinctly put, Fujian Yuanli Active CarbonLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that Fujian Yuanli Active CarbonLtd has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Fujian Yuanli Active CarbonLtd's ability to maintain a healthy balance sheet going forward. 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 Fujian Yuanli Active CarbonLtd 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. During the last three years, Fujian Yuanli Active CarbonLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Fujian Yuanli Active CarbonLtd has net cash of CN¥1.12b, as well as more liquid assets than liabilities. So we are not troubled with Fujian Yuanli Active CarbonLtd's debt use. 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. To that end, you should be aware of the 1 warning sign we've spotted with Fujian Yuanli Active CarbonLtd .

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.