The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 note that Kingboard Laminates Holdings Limited (HKG:1888) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

View our latest analysis for Kingboard Laminates Holdings

How Much Debt Does Kingboard Laminates Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that Kingboard Laminates Holdings had HK$2.95b of debt in December 2019, down from HK$5.84b, one year before. But it also has HK$3.71b in cash to offset that, meaning it has HK$759.9m net cash.

How Strong Is Kingboard Laminates Holdings's Balance Sheet?

The latest balance sheet data shows that Kingboard Laminates Holdings had liabilities of HK$5.32b due within a year, and liabilities of HK$1.74b falling due after that. Offsetting these obligations, it had cash of HK$3.71b as well as receivables valued at HK$7.20b due within 12 months. So it actually has HK$3.85b more liquid assets than total liabilities.

This surplus suggests that Kingboard Laminates Holdings is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that Kingboard Laminates Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Kingboard Laminates Holdings if management cannot prevent a repeat of the 26% cut to EBIT 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 ultimately the future profitability of the business will decide if Kingboard Laminates Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Kingboard Laminates Holdings 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, Kingboard Laminates Holdings produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While it is always sensible to investigate a company's debt, in this case Kingboard Laminates Holdings has HK$759.9m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 68% of that EBIT to free cash flow, bringing in HK$3.4b. So we are not troubled with Kingboard Laminates Holdings's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Kingboard Laminates Holdings that you should be aware of before investing here.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.