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.' 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 note that Avary Holding(Shenzhen)Co., Limited (SZSE:002938) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Avary Holding(Shenzhen)Co's Debt?

You can click the graphic below for the historical numbers, but it shows that Avary Holding(Shenzhen)Co had CN¥3.47b of debt in March 2024, down from CN¥3.92b, one year before. However, its balance sheet shows it holds CN¥11.8b in cash, so it actually has CN¥8.32b net cash.

How Strong Is Avary Holding(Shenzhen)Co's Balance Sheet?

According to the last reported balance sheet, Avary Holding(Shenzhen)Co had liabilities of CN¥9.24b due within 12 months, and liabilities of CN¥783.6m due beyond 12 months. Offsetting these obligations, it had cash of CN¥11.8b as well as receivables valued at CN¥3.93b due within 12 months. So it can boast CN¥5.69b more liquid assets than total liabilities.

This short term liquidity is a sign that Avary Holding(Shenzhen)Co could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Avary Holding(Shenzhen)Co boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Avary Holding(Shenzhen)Co's load is not too heavy, because its EBIT was down 44% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Avary Holding(Shenzhen)Co 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Avary Holding(Shenzhen)Co 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, Avary Holding(Shenzhen)Co generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Avary Holding(Shenzhen)Co has net cash of CN¥8.32b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥4.1b, being 82% of its EBIT. So we don't have any problem with Avary Holding(Shenzhen)Co's use of debt. 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. Be aware that Avary Holding(Shenzhen)Co is showing 1 warning sign in our investment analysis , you should know about...

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com