Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, VATS Liquor Chain Store Management Joint Stock Co., Ltd. (SZSE:300755) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 step when considering a company's debt levels is to consider its cash and debt together.

What Is VATS Liquor Chain Store Management's Debt?

The chart below, which you can click on for greater detail, shows that VATS Liquor Chain Store Management had CN¥1.41b in debt in June 2024; about the same as the year before. However, it also had CN¥1.01b in cash, and so its net debt is CN¥404.5m.

A Look At VATS Liquor Chain Store Management's Liabilities

The latest balance sheet data shows that VATS Liquor Chain Store Management had liabilities of CN¥3.07b due within a year, and liabilities of CN¥59.1m falling due after that. Offsetting these obligations, it had cash of CN¥1.01b as well as receivables valued at CN¥410.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.71b.

This deficit isn't so bad because VATS Liquor Chain Store Management is worth CN¥6.84b, 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

VATS Liquor Chain Store Management's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its strong interest cover of 10.3 times, makes us even more comfortable. Fortunately, VATS Liquor Chain Store Management grew its EBIT by 4.2% in the last year, making that debt load look even more manageable. 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 VATS Liquor Chain Store Management's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, VATS Liquor Chain Store Management saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

VATS Liquor Chain Store Management's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its interest cover was refreshing. Looking at all the angles mentioned above, it does seem to us that VATS Liquor Chain Store Management is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for VATS Liquor Chain Store Management you should be aware of, and 1 of them is a bit concerning.

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.

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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.