Arrail Group (HKG:6639) Seems To Use Debt Quite Sensibly

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 can see that Arrail Group Limited (HKG:6639) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Arrail Group

What Is Arrail Group's Debt?

As you can see below, at the end of March 2024, Arrail Group had CN¥355.6m of debt, up from CN¥220.0m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥1.10b in cash, so it actually has CN¥747.5m net cash.

How Healthy Is Arrail Group's Balance Sheet?

The latest balance sheet data shows that Arrail Group had liabilities of CN¥840.3m due within a year, and liabilities of CN¥575.4m falling due after that. On the other hand, it had cash of CN¥1.10b and CN¥272.8m worth of receivables due within a year. So its liabilities total CN¥39.8m more than the combination of its cash and short-term receivables.

Given Arrail Group has a market capitalization of CN¥1.36b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Arrail Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

We also note that Arrail Group improved its EBIT from a last year's loss to a positive CN¥4.9m. 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 Arrail Group 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 Arrail Group 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 year, Arrail Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Arrail Group has CN¥747.5m in net cash. And it impressed us with free cash flow of CN¥184m, being 3,798% of its EBIT. So we are not troubled with Arrail Group's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Arrail Group that you should be aware of before investing here.

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.