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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Arcplus Group PLC (SHSE:600629) does carry 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Arcplus Group's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Arcplus Group had debt of CN¥258.2m, up from CN¥209.9m in one year. But it also has CN¥2.69b in cash to offset that, meaning it has CN¥2.43b net cash.

How Healthy Is Arcplus Group's Balance Sheet?

The latest balance sheet data shows that Arcplus Group had liabilities of CN¥8.70b due within a year, and liabilities of CN¥960.6m falling due after that. Offsetting this, it had CN¥2.69b in cash and CN¥5.09b in receivables that were due within 12 months. So it has liabilities totalling CN¥1.88b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Arcplus Group is worth CN¥5.12b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Arcplus Group boasts net cash, so it's fair to say it does not have a heavy debt load!

Fortunately, Arcplus Group grew its EBIT by 9.6% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Arcplus Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Arcplus Group 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, Arcplus Group recorded free cash flow worth a fulsome 94% 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 Arcplus Group does have more liabilities than liquid assets, it also has net cash of CN¥2.43b. And it impressed us with free cash flow of CN¥282m, being 94% of its EBIT. So we don't think Arcplus Group's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Arcplus Group 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.