David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Vatti Corporation Limited (SZSE:002035) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Vatti Carry?

You can click the graphic below for the historical numbers, but it shows that Vatti had CN¥50.0m of debt in March 2024, down from CN¥211.8m, one year before. However, its balance sheet shows it holds CN¥3.05b in cash, so it actually has CN¥3.00b net cash.

A Look At Vatti's Liabilities

According to the last reported balance sheet, Vatti had liabilities of CN¥3.29b due within 12 months, and liabilities of CN¥32.5m due beyond 12 months. Offsetting these obligations, it had cash of CN¥3.05b as well as receivables valued at CN¥1.03b due within 12 months. So it actually has CN¥747.0m more liquid assets than total liabilities.

This surplus suggests that Vatti has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Vatti boasts net cash, so it's fair to say it does not have a heavy debt load!

Better yet, Vatti grew its EBIT by 406% 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 it is future earnings, more than anything, that will determine Vatti'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Vatti 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, Vatti 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

While it is always sensible to investigate a company's debt, in this case Vatti has CN¥3.00b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥1.2b, being 205% of its EBIT. So we don't think Vatti's use of debt is risky. 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 Vatti is showing 1 warning sign in our investment analysis , you should know about...

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.