Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that FangDa Carbon New Material Co.,Ltd (SHSE:600516) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.

How Much Debt Does FangDa Carbon New MaterialLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 FangDa Carbon New MaterialLtd had CN¥1.19b of debt, an increase on CN¥641.4m, over one year. But on the other hand it also has CN¥6.83b in cash, leading to a CN¥5.63b net cash position.

A Look At FangDa Carbon New MaterialLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that FangDa Carbon New MaterialLtd had liabilities of CN¥2.37b due within 12 months and liabilities of CN¥1.06b due beyond that. Offsetting this, it had CN¥6.83b in cash and CN¥2.18b in receivables that were due within 12 months. So it actually has CN¥5.58b more liquid assets than total liabilities.

This surplus suggests that FangDa Carbon New MaterialLtd is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that FangDa Carbon New MaterialLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact FangDa Carbon New MaterialLtd's saving grace is its low debt levels, because its EBIT has tanked 58% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 FangDa Carbon New MaterialLtd'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. While FangDa Carbon New MaterialLtd 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, FangDa Carbon New MaterialLtd recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that FangDa Carbon New MaterialLtd has net cash of CN¥5.63b, as well as more liquid assets than liabilities. So we don't have any problem with FangDa Carbon New MaterialLtd's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for FangDa Carbon New MaterialLtd you should know about.

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.