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 can see that Shantui Construction Machinery Co., Ltd. (SZSE:000680) does use debt in its business. 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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Shantui Construction Machinery's Debt?
The chart below, which you can click on for greater detail, shows that Shantui Construction Machinery had CN¥760.7m in debt in March 2024; about the same as the year before. However, it does have CN¥3.47b in cash offsetting this, leading to net cash of CN¥2.70b.
How Strong Is Shantui Construction Machinery's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Shantui Construction Machinery had liabilities of CN¥7.75b due within 12 months and liabilities of CN¥399.5m due beyond that. Offsetting this, it had CN¥3.47b in cash and CN¥4.66b in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
Having regard to Shantui Construction Machinery's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥13.3b company is struggling for cash, we still think it's worth monitoring its balance sheet. Despite its noteworthy liabilities, Shantui Construction Machinery boasts net cash, so it's fair to say it does not have a heavy debt load!
Even more impressive was the fact that Shantui Construction Machinery grew its EBIT by 124% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shantui Construction Machinery's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Shantui Construction Machinery 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. Looking at the most recent three years, Shantui Construction Machinery recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Summing Up
While it is always sensible to look at a company's total liabilities, it is very reassuring that Shantui Construction Machinery has CN¥2.70b in net cash. And it impressed us with its EBIT growth of 124% over the last year. So we don't think Shantui Construction Machinery's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Shantui Construction Machinery (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
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.