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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Nanjing Xinjiekou Department Store Co., Ltd. (SHSE:600682) does use debt in its business. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Nanjing Xinjiekou Department Store

What Is Nanjing Xinjiekou Department Store's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Nanjing Xinjiekou Department Store had CN¥870.6m of debt in September 2023, down from CN¥907.3m, one year before. However, it does have CN¥5.63b in cash offsetting this, leading to net cash of CN¥4.76b.

A Look At Nanjing Xinjiekou Department Store's Liabilities

We can see from the most recent balance sheet that Nanjing Xinjiekou Department Store had liabilities of CN¥5.92b falling due within a year, and liabilities of CN¥1.08b due beyond that. Offsetting these obligations, it had cash of CN¥5.63b as well as receivables valued at CN¥1.38b due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

Having regard to Nanjing Xinjiekou Department Store's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥10.5b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Nanjing Xinjiekou Department Store has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Nanjing Xinjiekou Department Store if management cannot prevent a repeat of the 33% 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 ultimately the future profitability of the business will decide if Nanjing Xinjiekou Department Store 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Nanjing Xinjiekou Department Store 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. Happily for any shareholders, Nanjing Xinjiekou Department Store actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While it is always sensible to investigate a company's debt, in this case Nanjing Xinjiekou Department Store has CN¥4.76b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 107% of that EBIT to free cash flow, bringing in CN¥699m. So we are not troubled with Nanjing Xinjiekou Department Store's debt use. 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. Be aware that Nanjing Xinjiekou Department Store is showing 1 warning sign in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.