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.' 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 Vector Limited (NZSE:VCT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Vector Carry?

As you can see below, Vector had NZ$2.17b of debt at December 2024, down from NZ$2.27b a year prior. Net debt is about the same, since the it doesn't have much cash.

A Look At Vector's Liabilities

Zooming in on the latest balance sheet data, we can see that Vector had liabilities of NZ$534.1m due within 12 months and liabilities of NZ$2.88b due beyond that. Offsetting these obligations, it had cash of NZ$8.70m as well as receivables valued at NZ$178.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$3.23b.

This is a mountain of leverage relative to its market capitalization of NZ$3.98b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

Check out our latest analysis for Vector

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Vector has a debt to EBITDA ratio of 3.7 and its EBIT covered its interest expense 5.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. It is well worth noting that Vector's EBIT shot up like bamboo after rain, gaining 32% in the last twelve months. That'll make it easier to manage its 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 Vector 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Vector burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Vector's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. It's also worth noting that Vector is in the Integrated Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Vector's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Vector (of which 1 shouldn't be ignored!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.