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.' 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 Cavco Industries, Inc. (NASDAQ:CVCO) makes use of debt. But is this debt a concern to shareholders?

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. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Cavco Industries's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Cavco Industries had debt of US$1.85m, up from US$1.69m in one year. However, it does have US$380.0m in cash offsetting this, leading to net cash of US$378.1m.

How Strong Is Cavco Industries' Balance Sheet?

We can see from the most recent balance sheet that Cavco Industries had liabilities of US$296.0m falling due within a year, and liabilities of US$46.1m due beyond that. Offsetting these obligations, it had cash of US$380.0m as well as receivables valued at US$85.1m due within 12 months. So it can boast US$122.9m more liquid assets than total liabilities.

This surplus suggests that Cavco Industries has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Cavco Industries has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Cavco Industries's saving grace is its low debt levels, because its EBIT has tanked 42% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Cavco Industries'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Cavco Industries 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 last three years, Cavco Industries recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Cavco Industries has net cash of US$378.1m, as well as more liquid assets than liabilities. The cherry on top was that in converted 83% of that EBIT to free cash flow, bringing in US$172m. So we don't have any problem with Cavco Industries's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in Cavco Industries, you may well want to click here to check an interactive graph of its earnings per share history.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.