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 Toread Holdings Group Co., Ltd. (SZSE:300005) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 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 think about a company's use of debt, we first look at cash and debt together.

What Is Toread Holdings Group's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Toread Holdings Group had debt of CN¥170.2m, up from CN¥25.2m in one year. However, its balance sheet shows it holds CN¥909.6m in cash, so it actually has CN¥739.4m net cash.

How Strong Is Toread Holdings Group's Balance Sheet?

According to the last reported balance sheet, Toread Holdings Group had liabilities of CN¥519.3m due within 12 months, and liabilities of CN¥164.9m due beyond 12 months. Offsetting this, it had CN¥909.6m in cash and CN¥376.2m in receivables that were due within 12 months. So it can boast CN¥601.6m more liquid assets than total liabilities.

This short term liquidity is a sign that Toread Holdings Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Toread Holdings Group boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that Toread Holdings Group has seen its EBIT plunge 18% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Toread Holdings Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Toread Holdings 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 two years, Toread Holdings Group actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Toread Holdings Group has net cash of CN¥739.4m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥205m, being 347% of its EBIT. So we don't have any problem with Toread Holdings Group'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 Toread Holdings Group has 2 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

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.