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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Deluxe Family Co., Ltd. (SHSE:600503) does use debt in its business. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Deluxe Family Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Deluxe Family had debt of CN¥200.0m, up from none in one year. But on the other hand it also has CN¥771.3m in cash, leading to a CN¥571.3m net cash position.

How Strong Is Deluxe Family's Balance Sheet?

We can see from the most recent balance sheet that Deluxe Family had liabilities of CN¥421.5m falling due within a year, and liabilities of CN¥213.7m due beyond that. Offsetting this, it had CN¥771.3m in cash and CN¥34.1m in receivables that were due within 12 months. So it actually has CN¥170.3m more liquid assets than total liabilities.

This short term liquidity is a sign that Deluxe Family could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Deluxe Family has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Deluxe Family grew its EBIT by 1,413% over twelve months. 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 it is Deluxe Family's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Deluxe Family 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. During the last two years, Deluxe Family burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Deluxe Family has net cash of CN¥571.3m, as well as more liquid assets than liabilities. And we liked the look of last year's 1,413% year-on-year EBIT growth. So we don't have any problem with Deluxe Family'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. For example - Deluxe Family has 1 warning sign we think you should be aware of.

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.