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. As with many other companies Vatti Corporation Limited (SZSE:002035) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Vatti Carry?

As you can see below, Vatti had CN¥76.9m of debt at September 2024, down from CN¥127.6m a year prior. However, it does have CN¥2.80b in cash offsetting this, leading to net cash of CN¥2.72b.

How Strong Is Vatti's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Vatti had liabilities of CN¥3.20b due within 12 months and liabilities of CN¥54.5m due beyond that. Offsetting these obligations, it had cash of CN¥2.80b as well as receivables valued at CN¥1.14b due within 12 months. So it can boast CN¥691.6m more liquid assets than total liabilities.

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

Even more impressive was the fact that Vatti grew its EBIT by 166% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Vatti 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Vatti 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. Over the last three years, Vatti 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 it is always sensible to investigate a company's debt, in this case Vatti has CN¥2.72b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 168% of that EBIT to free cash flow, bringing in CN¥574m. So we don't think Vatti's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Vatti has 1 warning sign we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.