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 Innuovo Technology Co., Ltd. (SZSE:000795) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

What Is Innuovo Technology's Net Debt?

The image below, which you can click on for greater detail, shows that Innuovo Technology had debt of CN¥424.6m at the end of March 2024, a reduction from CN¥1.39b over a year. But on the other hand it also has CN¥673.1m in cash, leading to a CN¥248.5m net cash position.

A Look At Innuovo Technology's Liabilities

We can see from the most recent balance sheet that Innuovo Technology had liabilities of CN¥1.25b falling due within a year, and liabilities of CN¥71.6m due beyond that. Offsetting this, it had CN¥673.1m in cash and CN¥1.05b in receivables that were due within 12 months. So it can boast CN¥397.5m more liquid assets than total liabilities.

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

It is just as well that Innuovo Technology's load is not too heavy, because its EBIT was down 31% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Innuovo Technology will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Innuovo Technology 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. In the last three years, Innuovo Technology created free cash flow amounting to 6.2% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Innuovo Technology has net cash of CN¥248.5m, as well as more liquid assets than liabilities. So we are not troubled with Innuovo Technology's debt use. There's no doubt that we learn most about debt from the balance sheet. 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 Innuovo Technology you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.