Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Lovisa Holdings Limited (ASX:LOV) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Lovisa Holdings

What Is Lovisa Holdings's Debt?

The image below, which you can click on for greater detail, shows that at December 2024 Lovisa Holdings had debt of AU$48.0m, up from AU$43.0m in one year. But on the other hand it also has AU$54.7m in cash, leading to a AU$6.71m net cash position.

How Healthy Is Lovisa Holdings' Balance Sheet?

The latest balance sheet data shows that Lovisa Holdings had liabilities of AU$160.8m due within a year, and liabilities of AU$334.2m falling due after that. On the other hand, it had cash of AU$54.7m and AU$34.5m worth of receivables due within a year. So its liabilities total AU$405.8m more than the combination of its cash and short-term receivables.

Given Lovisa Holdings has a market capitalization of AU$2.67b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Lovisa Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

Also good is that Lovisa Holdings grew its EBIT at 15% over the last year, further increasing its ability to manage debt. 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 Lovisa 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Lovisa Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Lovisa Holdings recorded free cash flow worth a fulsome 96% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

Although Lovisa Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$6.71m. The cherry on top was that in converted 96% of that EBIT to free cash flow, bringing in AU$142m. So is Lovisa Holdings's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Lovisa Holdings that you should be aware of.

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.

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.