David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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, Three Squirrels Inc. (SZSE:300783) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Three Squirrels's Debt?

The image below, which you can click on for greater detail, shows that Three Squirrels had debt of CN¥312.1m at the end of September 2024, a reduction from CN¥512.2m over a year. But it also has CN¥414.1m in cash to offset that, meaning it has CN¥102.1m net cash.

How Strong Is Three Squirrels' Balance Sheet?

We can see from the most recent balance sheet that Three Squirrels had liabilities of CN¥1.53b falling due within a year, and liabilities of CN¥257.5m due beyond that. Offsetting these obligations, it had cash of CN¥414.1m as well as receivables valued at CN¥469.5m due within 12 months. So it has liabilities totalling CN¥901.8m more than its cash and near-term receivables, combined.

Of course, Three Squirrels has a market capitalization of CN¥13.9b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Three Squirrels also has more cash than debt, so we're pretty confident it can manage its debt safely.

Better yet, Three Squirrels grew its EBIT by 110% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Three Squirrels can strengthen its balance sheet over time. 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. While Three Squirrels 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. Considering the last two years, Three Squirrels actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Three Squirrels has CN¥102.1m in net cash. And we liked the look of last year's 110% year-on-year EBIT growth. So we don't have any problem with Three Squirrels's use of debt. 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. Be aware that Three Squirrels is showing 3 warning signs in our investment analysis , 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.