Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Three Squirrels Inc. (SZSE:300783) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Three Squirrels's Debt?
The image below, which you can click on for greater detail, shows that at December 2023 Three Squirrels had debt of CN¥479.7m, up from CN¥249.7m in one year. However, its balance sheet shows it holds CN¥1.79b in cash, so it actually has CN¥1.31b net cash.
How Strong Is Three Squirrels' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Three Squirrels had liabilities of CN¥2.76b due within 12 months and liabilities of CN¥268.9m due beyond that. Offsetting these obligations, it had cash of CN¥1.79b as well as receivables valued at CN¥782.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥453.7m.
Given Three Squirrels has a market capitalization of CN¥9.12b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Three Squirrels boasts net cash, so it's fair to say it does not have a heavy debt load!
Better yet, Three Squirrels grew its EBIT by 188% last year, which is an impressive improvement. 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 Three Squirrels 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Three Squirrels 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, Three Squirrels 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
We could understand if investors are concerned about Three Squirrels's liabilities, but we can be reassured by the fact it has has net cash of CN¥1.31b. And it impressed us with free cash flow of CN¥264m, being 113% of its EBIT. So is Three Squirrels's debt a risk? It doesn't seem so to us. 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. We've identified 2 warning signs with Three Squirrels , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.