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. 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 Sinopec Shanghai Petrochemical Company Limited (HKG:338) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Sinopec Shanghai Petrochemical

What Is Sinopec Shanghai Petrochemical's Net Debt?

As you can see below, Sinopec Shanghai Petrochemical had CN¥994.6m of debt at September 2019, down from CN¥1.87b a year prior. But it also has CN¥9.76b in cash to offset that, meaning it has CN¥8.76b net cash.

A Look At Sinopec Shanghai Petrochemical's Liabilities

We can see from the most recent balance sheet that Sinopec Shanghai Petrochemical had liabilities of CN¥9.85b falling due within a year, and liabilities of CN¥163.8m due beyond that. Offsetting this, it had CN¥9.76b in cash and CN¥3.74b in receivables that were due within 12 months. So it can boast CN¥3.48b more liquid assets than total liabilities.

This short term liquidity is a sign that Sinopec Shanghai Petrochemical could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Sinopec Shanghai Petrochemical has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Sinopec Shanghai Petrochemical's load is not too heavy, because its EBIT was down 80% over the last year. 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 ultimately the future profitability of the business will decide if Sinopec Shanghai Petrochemical can strengthen its balance sheet over time. 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. Sinopec Shanghai Petrochemical 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. Over the most recent three years, Sinopec Shanghai Petrochemical recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Sinopec Shanghai Petrochemical has net cash of CN¥8.76b, as well as more liquid assets than liabilities. The cherry on top was that in converted 79% of that EBIT to free cash flow, bringing in CN¥1.4b. So we are not troubled with Sinopec Shanghai Petrochemical's debt use. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Sinopec Shanghai Petrochemical's dividend history, without delay!

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.