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 AEM Holdings Ltd. (SGX:AWX) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is AEM Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that AEM Holdings had S$92.0m of debt in December 2023, down from S$108.1m, one year before. However, its balance sheet shows it holds S$101.8m in cash, so it actually has S$9.85m net cash.

How Healthy Is AEM Holdings' Balance Sheet?

The latest balance sheet data shows that AEM Holdings had liabilities of S$177.5m due within a year, and liabilities of S$57.0m falling due after that. Offsetting these obligations, it had cash of S$101.8m as well as receivables valued at S$61.7m due within 12 months. So its liabilities total S$70.9m more than the combination of its cash and short-term receivables.

Given AEM Holdings has a market capitalization of S$745.1m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, AEM Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

It is just as well that AEM Holdings's load is not too heavy, because its EBIT was down 73% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AEM Holdings 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. AEM Holdings 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 three years, AEM Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Summing Up

We could understand if investors are concerned about AEM Holdings's liabilities, but we can be reassured by the fact it has has net cash of S$9.85m. So although we see some areas for improvement, we're not too worried about AEM Holdings's balance sheet. Given our hesitation about the stock, it would be good to know if AEM Holdings insiders have sold any shares recently. You click here to find out if insiders have sold recently.

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.