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. Importantly, AEI Corporation Ltd. (SGX:AWG) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 AEI

What Is AEI's Debt?

As you can see below, AEI had S$2.56m of debt at June 2019, down from S$2.93m a year prior. However, it does have S$36.9m in cash offsetting this, leading to net cash of S$34.4m.

How Strong Is AEI's Balance Sheet?

The latest balance sheet data shows that AEI had liabilities of S$3.72m due within a year, and liabilities of S$10.0m falling due after that. Offsetting these obligations, it had cash of S$36.9m as well as receivables valued at S$2.11m due within 12 months. So it actually has S$25.3m more liquid assets than total liabilities.

This excess liquidity is a great indication that AEI's balance sheet is just as strong as racists are weak. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Succinctly put, AEI boasts net cash, so it's fair to say it does not have a heavy debt load!

It was also good to see that despite losing money on the EBIT line last year, AEI turned things around in the last 12 months, delivering and EBIT of S$3.9m. There's no doubt that we learn most about debt from the balance sheet. But it is AEI'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. AEI 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 year, AEI saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing up

While it is always sensible to investigate a company's debt, in this case AEI has S$34.4m in net cash and a decent-looking balance sheet. So we don't have any problem with AEI's use of debt. 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. Case in point: We've spotted 5 warning signs for AEI you should be aware of, and 2 of them can't be ignored.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.