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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Atour Lifestyle Holdings Limited (NASDAQ:ATAT) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Atour Lifestyle Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that Atour Lifestyle Holdings had debt of CN¥72.0m at the end of December 2023, a reduction from CN¥174.0m over a year. But it also has CN¥3.59b in cash to offset that, meaning it has CN¥3.52b net cash.

A Look At Atour Lifestyle Holdings' Liabilities

According to the last reported balance sheet, Atour Lifestyle Holdings had liabilities of CN¥2.38b due within 12 months, and liabilities of CN¥2.15b due beyond 12 months. On the other hand, it had cash of CN¥3.59b and CN¥278.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥656.3m.

Of course, Atour Lifestyle Holdings has a market capitalization of CN¥17.7b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Atour Lifestyle Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

Better yet, Atour Lifestyle Holdings grew its EBIT by 460% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Atour Lifestyle Holdings's ability to maintain a healthy balance sheet going forward. 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. While Atour Lifestyle 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. Over the last three years, Atour Lifestyle Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Atour Lifestyle Holdings has CN¥3.52b in net cash. The cherry on top was that in converted 198% of that EBIT to free cash flow, bringing in CN¥1.9b. So we don't think Atour Lifestyle Holdings'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. For example - Atour Lifestyle Holdings has 1 warning sign we think 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.

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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.