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.' 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. We can see that North Industries Group Red Arrow Co., Ltd (SZSE:000519) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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 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, 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.
View our latest analysis for North Industries Group Red Arrow
How Much Debt Does North Industries Group Red Arrow Carry?
As you can see below, at the end of September 2023, North Industries Group Red Arrow had CN¥326.2m of debt, up from CN¥170.0m a year ago. Click the image for more detail. But on the other hand it also has CN¥5.77b in cash, leading to a CN¥5.45b net cash position.
How Healthy Is North Industries Group Red Arrow's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that North Industries Group Red Arrow had liabilities of CN¥3.79b due within 12 months and liabilities of CN¥519.4m due beyond that. Offsetting these obligations, it had cash of CN¥5.77b as well as receivables valued at CN¥1.45b due within 12 months. So it can boast CN¥2.92b more liquid assets than total liabilities.
This excess liquidity suggests that North Industries Group Red Arrow is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Succinctly put, North Industries Group Red Arrow boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that North Industries Group Red Arrow's load is not too heavy, because its EBIT was down 94% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 North Industries Group Red Arrow's ability to maintain a healthy balance sheet going forward. 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. North Industries Group Red Arrow 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. During the last three years, North Industries Group Red Arrow generated free cash flow amounting to a very robust 88% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that North Industries Group Red Arrow has net cash of CN¥5.45b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥378m, being 88% of its EBIT. So is North Industries Group Red Arrow's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with North Industries Group Red Arrow .
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.