ExtremeLtd (TSE:6033) Could Easily Take On More Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Extreme Co.,Ltd. (TSE:6033) does use debt in its business. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for ExtremeLtd

What Is ExtremeLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that ExtremeLtd had JP¥683.0m of debt in September 2024, down from JP¥921.0m, one year before. But it also has JP¥3.80b in cash to offset that, meaning it has JP¥3.12b net cash.

How Strong Is ExtremeLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that ExtremeLtd had liabilities of JP¥2.31b due within 12 months and liabilities of JP¥30.0m due beyond that. Offsetting this, it had JP¥3.80b in cash and JP¥1.61b in receivables that were due within 12 months. So it actually has JP¥3.07b more liquid assets than total liabilities.

This excess liquidity is a great indication that ExtremeLtd's balance sheet is almost as strong as Fort Knox. Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that ExtremeLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

Fortunately, ExtremeLtd grew its EBIT by 4.3% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But it is ExtremeLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While ExtremeLtd 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 most recent three years, ExtremeLtd recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that ExtremeLtd has net cash of JP¥3.12b, as well as more liquid assets than liabilities. So we don't think ExtremeLtd's use of debt is risky. 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. Be aware that ExtremeLtd is showing 4 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.