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 LB Group Co., Ltd. (SZSE:002601) does use debt in its business. 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

What Is LB Group's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 LB Group had debt of CN¥23.4b, up from CN¥20.1b in one year. However, it does have CN¥9.02b in cash offsetting this, leading to net debt of about CN¥14.4b.

How Healthy Is LB Group's Balance Sheet?

The latest balance sheet data shows that LB Group had liabilities of CN¥30.8b due within a year, and liabilities of CN¥11.0b falling due after that. On the other hand, it had cash of CN¥9.02b and CN¥6.05b worth of receivables due within a year. So its liabilities total CN¥26.7b more than the combination of its cash and short-term receivables.

LB Group has a market capitalization of CN¥47.1b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

LB Group's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 13.2 times its interest expense, implies the debt load is as light as a peacock feather. Importantly, LB Group grew its EBIT by 59% 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 ultimately the future profitability of the business will decide if LB Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, LB Group created free cash flow amounting to 4.7% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Both LB Group's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its conversion of EBIT to free cash flow had us nibbling our nails. Looking at all this data makes us feel a little cautious about LB Group's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that LB Group is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.