Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Lenovo Group Limited (HKG:992) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Lenovo Group Carry?

You can click the graphic below for the historical numbers, but it shows that Lenovo Group had US$3.62b of debt in December 2023, down from US$4.50b, one year before. On the flip side, it has US$3.57b in cash leading to net debt of about US$53.8m.

How Strong Is Lenovo Group's Balance Sheet?

The latest balance sheet data shows that Lenovo Group had liabilities of US$26.7b due within a year, and liabilities of US$6.69b falling due after that. Offsetting these obligations, it had cash of US$3.57b as well as receivables valued at US$12.1b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$17.8b.

Given this deficit is actually higher than the company's massive market capitalization of US$14.3b, we think shareholders really should watch Lenovo Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Lenovo Group has a very little net debt but plenty of other liabilities weighing it down.

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.

With debt at a measly 0.021 times EBITDA and EBIT covering interest a whopping 13.3 times, it's clear that Lenovo Group is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. It is just as well that Lenovo Group's load is not too heavy, because its EBIT was down 45% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Lenovo 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Lenovo Group produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We feel some trepidation about Lenovo Group's difficulty EBIT growth rate, but we've got positives to focus on, too. For example, its interest cover and net debt to EBITDA give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Lenovo Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Lenovo Group is showing 3 warning signs in our investment analysis , you should know about...

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.