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. As with many other companies Zhongji Innolight Co., Ltd. (SZSE:300308) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Zhongji Innolight's Net Debt?

As you can see below, Zhongji Innolight had CN¥1.27b of debt at March 2024, down from CN¥1.84b a year prior. But it also has CN¥4.04b in cash to offset that, meaning it has CN¥2.77b net cash.

How Healthy Is Zhongji Innolight's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhongji Innolight had liabilities of CN¥4.54b due within 12 months and liabilities of CN¥1.15b due beyond that. On the other hand, it had cash of CN¥4.04b and CN¥3.67b worth of receivables due within a year. So it actually has CN¥2.03b more liquid assets than total liabilities.

Having regard to Zhongji Innolight'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¥134.6b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that Zhongji Innolight has more cash than debt is arguably a good indication that it can manage its debt safely.

Better yet, Zhongji Innolight grew its EBIT by 131% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Zhongji Innolight'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Zhongji Innolight 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. Looking at the most recent three years, Zhongji Innolight recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Zhongji Innolight has net cash of CN¥2.77b, as well as more liquid assets than liabilities. And we liked the look of last year's 131% year-on-year EBIT growth. So we don't think Zhongji Innolight's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Zhongji Innolight (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

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.