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.' 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 UFP Technologies, Inc. (NASDAQ:UFPT) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

What Is UFP Technologies's Debt?

As you can see below, UFP Technologies had US$35.2m of debt at June 2024, down from US$57.0m a year prior. However, it does have US$16.7m in cash offsetting this, leading to net debt of about US$18.5m.

A Look At UFP Technologies' Liabilities

The latest balance sheet data shows that UFP Technologies had liabilities of US$51.8m due within a year, and liabilities of US$60.4m falling due after that. Offsetting these obligations, it had cash of US$16.7m as well as receivables valued at US$63.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$32.3m.

Having regard to UFP Technologies' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$2.62b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, UFP Technologies has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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.

UFP Technologies has a low net debt to EBITDA ratio of only 0.24. And its EBIT easily covers its interest expense, being 22.0 times the size. So we're pretty relaxed about its super-conservative use of debt. The good news is that UFP Technologies has increased its EBIT by 9.4% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine UFP Technologies's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, UFP Technologies recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, UFP Technologies's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. It's also worth noting that UFP Technologies is in the Medical Equipment industry, which is often considered to be quite defensive. Zooming out, UFP Technologies seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. We've identified 1 warning sign with UFP Technologies , and understanding them should be part of your investment process.

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.

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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.