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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that DHC Software Co.,Ltd. (SZSE:002065) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is DHC SoftwareLtd's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 DHC SoftwareLtd had debt of CN¥4.60b, up from CN¥3.64b in one year. However, because it has a cash reserve of CN¥911.0m, its net debt is less, at about CN¥3.69b.

A Look At DHC SoftwareLtd's Liabilities

According to the last reported balance sheet, DHC SoftwareLtd had liabilities of CN¥10.9b due within 12 months, and liabilities of CN¥163.6m due beyond 12 months. Offsetting this, it had CN¥911.0m in cash and CN¥8.02b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.09b more than its cash and near-term receivables, combined.

Since publicly traded DHC SoftwareLtd shares are worth a total of CN¥13.9b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 6.1, it's fair to say DHC SoftwareLtd does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 6.0 times, suggesting it can responsibly service its obligations. Unfortunately, DHC SoftwareLtd's EBIT flopped 17% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But it is DHC SoftwareLtd'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, 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. Over the last three years, DHC SoftwareLtd recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both DHC SoftwareLtd's conversion of EBIT to free cash flow and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. Overall, we think it's fair to say that DHC SoftwareLtd has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For instance, we've identified 3 warning signs for DHC SoftwareLtd (1 makes us a bit uncomfortable) you should be aware of.

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.