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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. 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 Afya Limited (NASDAQ:AFYA) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Afya

What Is Afya's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2020 Afya had R$90.8m of debt, an increase on R$81.9m, over one year. But on the other hand it also has R$1.30b in cash, leading to a R$1.21b net cash position.

How Healthy Is Afya's Balance Sheet?

The latest balance sheet data shows that Afya had liabilities of R$400.1m due within a year, and liabilities of R$608.4m falling due after that. On the other hand, it had cash of R$1.30b and R$167.4m worth of receivables due within a year. So it can boast R$455.4m more liquid assets than total liabilities.

This short term liquidity is a sign that Afya could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Afya has more cash than debt is arguably a good indication that it can manage its debt safely.

On top of that, Afya grew its EBIT by 81% over the last twelve months, and that growth will make it easier to handle its debt. 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 Afya 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Afya 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. During the last three years, Afya produced sturdy free cash flow equating to 75% 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.