The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We can see that Adicon Holdings Limited (HKG:9860) does use debt in its business. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

How Much Debt Does Adicon Holdings Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Adicon Holdings had debt of CN¥1.19b, up from CN¥1.14b in one year. On the flip side, it has CN¥768.0m in cash leading to net debt of about CN¥425.0m.

How Strong Is Adicon Holdings' Balance Sheet?

The latest balance sheet data shows that Adicon Holdings had liabilities of CN¥1.58b due within a year, and liabilities of CN¥1.18b falling due after that. On the other hand, it had cash of CN¥768.0m and CN¥1.68b worth of receivables due within a year. So it has liabilities totalling CN¥310.1m more than its cash and near-term receivables, combined.

Given Adicon Holdings has a market capitalization of CN¥4.22b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Adicon Holdings's net debt is only 0.77 times its EBITDA. And its EBIT covers its interest expense a whopping 10.1 times over. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Adicon Holdings's load is not too heavy, because its EBIT was down 41% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Adicon Holdings'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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Adicon Holdings produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Adicon Holdings's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. We would also note that Healthcare industry companies like Adicon Holdings commonly do use debt without problems. When we consider all the elements mentioned above, it seems to us that Adicon Holdings is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Over time, share prices tend to follow earnings per share, so if you're interested in Adicon Holdings, you may well want to click here to check an interactive graph of its earnings per share history.

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.