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.' 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. Importantly, Zhejiang Xinan Chemical Industrial Group Co.,Ltd (SHSE:600596) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Zhejiang Xinan Chemical Industrial GroupLtd Carry?

As you can see below, at the end of March 2024, Zhejiang Xinan Chemical Industrial GroupLtd had CN¥4.44b of debt, up from CN¥3.01b a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥5.04b in cash, so it actually has CN¥596.2m net cash.

How Strong Is Zhejiang Xinan Chemical Industrial GroupLtd's Balance Sheet?

We can see from the most recent balance sheet that Zhejiang Xinan Chemical Industrial GroupLtd had liabilities of CN¥7.34b falling due within a year, and liabilities of CN¥2.68b due beyond that. Offsetting this, it had CN¥5.04b in cash and CN¥3.06b in receivables that were due within 12 months. So it has liabilities totalling CN¥1.93b more than its cash and near-term receivables, combined.

Since publicly traded Zhejiang Xinan Chemical Industrial GroupLtd shares are worth a total of CN¥12.1b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Zhejiang Xinan Chemical Industrial GroupLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Zhejiang Xinan Chemical Industrial GroupLtd if management cannot prevent a repeat of the 85% cut to EBIT over the last year. 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 it is future earnings, more than anything, that will determine Zhejiang Xinan Chemical Industrial GroupLtd'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Zhejiang Xinan Chemical Industrial GroupLtd 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. In the last three years, Zhejiang Xinan Chemical Industrial GroupLtd's free cash flow amounted to 28% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

Although Zhejiang Xinan Chemical Industrial GroupLtd's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥596.2m. So we don't have any problem with Zhejiang Xinan Chemical Industrial GroupLtd's use of debt. 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. Be aware that Zhejiang Xinan Chemical Industrial GroupLtd is showing 4 warning signs in our investment analysis , and 1 of those is a bit concerning...

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.