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. Importantly, Sun Art Retail Group Limited (HKG:6808) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Sun Art Retail Group's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Sun Art Retail Group had debt of CN¥2.98b, up from CN¥1.17b in one year. But it also has CN¥15.5b in cash to offset that, meaning it has CN¥12.5b net cash.

A Look At Sun Art Retail Group's Liabilities

We can see from the most recent balance sheet that Sun Art Retail Group had liabilities of CN¥34.9b falling due within a year, and liabilities of CN¥5.35b due beyond that. Offsetting these obligations, it had cash of CN¥15.5b as well as receivables valued at CN¥1.49b due within 12 months. So it has liabilities totalling CN¥23.2b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥21.9b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Given that Sun Art Retail Group has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

It is just as well that Sun Art Retail Group's load is not too heavy, because its EBIT was down 96% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Sun Art Retail Group'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. Sun Art Retail 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, Sun Art Retail Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While Sun Art Retail Group does have more liabilities than liquid assets, it also has net cash of CN¥12.5b. And it impressed us with free cash flow of -CN¥2.5b, being 451% of its EBIT. So although we see some areas for improvement, we're not too worried about Sun Art Retail Group's balance sheet. Even though Sun Art Retail Group lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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.