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 Anker Innovations Limited (SZSE:300866) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Anker Innovations Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Anker Innovations had debt of CN¥1.19b, up from CN¥933.3m in one year. But on the other hand it also has CN¥3.98b in cash, leading to a CN¥2.79b net cash position.

How Healthy Is Anker Innovations' Balance Sheet?

We can see from the most recent balance sheet that Anker Innovations had liabilities of CN¥3.41b falling due within a year, and liabilities of CN¥1.38b due beyond that. Offsetting this, it had CN¥3.98b in cash and CN¥1.48b in receivables that were due within 12 months. So it can boast CN¥665.2m more liquid assets than total liabilities.

Having regard to Anker Innovations' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥38.4b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that Anker Innovations has more cash than debt is arguably a good indication that it can manage its debt safely.

On top of that, Anker Innovations grew its EBIT by 64% over the last twelve months, and that growth will make it easier to handle its debt. 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 Anker Innovations'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. Anker Innovations 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. During the last three years, Anker Innovations produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Anker Innovations has net cash of CN¥2.79b, as well as more liquid assets than liabilities. And we liked the look of last year's 64% year-on-year EBIT growth. So we don't think Anker Innovations's use of debt is risky. 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. For instance, we've identified 1 warning sign for Anker Innovations that you should be aware of.

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.