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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Proya Cosmetics Co.,Ltd. (SHSE:603605) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Proya CosmeticsLtd Carry?

You can click the graphic below for the historical numbers, but it shows that Proya CosmeticsLtd had CN¥878.9m of debt in September 2024, down from CN¥949.1m, one year before. But it also has CN¥3.63b in cash to offset that, meaning it has CN¥2.75b net cash.

How Healthy Is Proya CosmeticsLtd's Balance Sheet?

We can see from the most recent balance sheet that Proya CosmeticsLtd had liabilities of CN¥1.76b falling due within a year, and liabilities of CN¥804.4m due beyond that. Offsetting this, it had CN¥3.63b in cash and CN¥330.1m in receivables that were due within 12 months. So it can boast CN¥1.40b more liquid assets than total liabilities.

This surplus suggests that Proya CosmeticsLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Proya CosmeticsLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

And we also note warmly that Proya CosmeticsLtd grew its EBIT by 14% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Proya CosmeticsLtd can strengthen its balance sheet over time. 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. Proya CosmeticsLtd 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 most recent three years, Proya CosmeticsLtd recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case Proya CosmeticsLtd has CN¥2.75b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 70% of that EBIT to free cash flow, bringing in CN¥888m. So is Proya CosmeticsLtd's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Proya CosmeticsLtd that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.