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.' 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. As with many other companies Proya Cosmetics Co.,Ltd. (SHSE:603605) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Proya CosmeticsLtd's Net Debt?

The chart below, which you can click on for greater detail, shows that Proya CosmeticsLtd had CN¥961.8m in debt in March 2024; about the same as the year before. However, it does have CN¥4.21b in cash offsetting this, leading to net cash of CN¥3.24b.

How Healthy Is Proya CosmeticsLtd's Balance Sheet?

According to the last reported balance sheet, Proya CosmeticsLtd had liabilities of CN¥2.39b due within 12 months, and liabilities of CN¥804.6m due beyond 12 months. Offsetting this, it had CN¥4.21b in cash and CN¥360.6m in receivables that were due within 12 months. So it actually has CN¥1.38b more liquid assets than total liabilities.

This surplus suggests that Proya CosmeticsLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Proya CosmeticsLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

On top of that, Proya CosmeticsLtd grew its EBIT by 31% over the last twelve months, and that growth will make it easier to handle its debt. 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 Proya CosmeticsLtd'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, a company can only pay off debt with cold hard cash, not accounting profits. Proya CosmeticsLtd 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, Proya CosmeticsLtd recorded free cash flow worth a fulsome 93% 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 Proya CosmeticsLtd has net cash of CN¥3.24b, as well as more liquid assets than liabilities. The cherry on top was that in converted 93% of that EBIT to free cash flow, bringing in CN¥1.3b. So is Proya CosmeticsLtd's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Proya CosmeticsLtd , and understanding them should be part of your investment process.

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.

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