Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 note that Topsports International Holdings Limited (HKG:6110) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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 Topsports International Holdings

What Is Topsports International Holdings's Debt?

As you can see below, at the end of August 2024, Topsports International Holdings had CN¥950.0m of debt, up from CN¥840.0m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥3.70b in cash, so it actually has CN¥2.75b net cash.

A Look At Topsports International Holdings' Liabilities

According to the last reported balance sheet, Topsports International Holdings had liabilities of CN¥3.89b due within 12 months, and liabilities of CN¥1.52b due beyond 12 months. Offsetting these obligations, it had cash of CN¥3.70b as well as receivables valued at CN¥949.4m due within 12 months. So its liabilities total CN¥756.0m more than the combination of its cash and short-term receivables.

Of course, Topsports International Holdings has a market capitalization of CN¥15.7b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Topsports International Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Topsports International Holdings's EBIT dived 14%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Topsports International Holdings 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Topsports International 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. Happily for any shareholders, Topsports International Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

We could understand if investors are concerned about Topsports International Holdings's liabilities, but we can be reassured by the fact it has has net cash of CN¥2.75b. And it impressed us with free cash flow of CN¥2.8b, being 148% of its EBIT. So we don't have any problem with Topsports International Holdings's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Topsports International Holdings you should be aware of.

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.