Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Sun Art Retail Group Limited (HKG:6808) does use debt in its business. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

What Is Sun Art Retail Group's Debt?

As you can see below, at the end of September 2023, Sun Art Retail Group had CN¥1.17b of debt, up from none a year ago. Click the image for more detail. But it also has CN¥20.8b in cash to offset that, meaning it has CN¥19.7b net cash.

How Healthy Is Sun Art Retail Group's Balance Sheet?

According to the last reported balance sheet, Sun Art Retail Group had liabilities of CN¥35.5b due within 12 months, and liabilities of CN¥6.31b due beyond 12 months. Offsetting these obligations, it had cash of CN¥20.8b as well as receivables valued at CN¥1.85b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥19.2b.

Given this deficit is actually higher than the company's market capitalization of CN¥12.9b, we think shareholders really should watch Sun Art Retail 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. Given that Sun Art Retail Group has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

It is just as well that Sun Art Retail Group's load is not too heavy, because its EBIT was down 21% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sun Art Retail Group'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Sun Art Retail Group 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, Sun Art Retail Group actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

Although Sun Art Retail Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥19.7b. The cherry on top was that in converted 338% of that EBIT to free cash flow, bringing in CN¥4.0b. So while Sun Art Retail Group does not have a great balance sheet, it's certainly not too bad. While Sun Art Retail Group didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.