David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Hydsoft Technology Co.,Ltd. (SZSE:301316) does carry debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Hydsoft TechnologyLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Hydsoft TechnologyLtd had CN¥155.5m of debt, an increase on CN¥127.1m, over one year. But it also has CN¥284.4m in cash to offset that, meaning it has CN¥128.9m net cash.

A Look At Hydsoft TechnologyLtd's Liabilities

The latest balance sheet data shows that Hydsoft TechnologyLtd had liabilities of CN¥348.9m due within a year, and liabilities of CN¥103.8m falling due after that. Offsetting this, it had CN¥284.4m in cash and CN¥669.6m in receivables that were due within 12 months. So it actually has CN¥501.3m more liquid assets than total liabilities.

This surplus suggests that Hydsoft TechnologyLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Hydsoft TechnologyLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

On the other hand, Hydsoft TechnologyLtd's EBIT dived 17%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hydsoft TechnologyLtd'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. Hydsoft TechnologyLtd 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. In the last three years, Hydsoft TechnologyLtd's free cash flow amounted to 23% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Hydsoft TechnologyLtd has net cash of CN¥128.9m, as well as more liquid assets than liabilities. So we don't have any problem with Hydsoft TechnologyLtd's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Hydsoft TechnologyLtd is showing 3 warning signs in our investment analysis , and 1 of those is significant...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.