Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that NetDragon Websoft Holdings Limited (HKG:777) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 think about a company's use of debt, we first look at cash and debt together.

What Is NetDragon Websoft Holdings's Debt?

The image below, which you can click on for greater detail, shows that NetDragon Websoft Holdings had debt of CN¥1.97b at the end of June 2024, a reduction from CN¥2.41b over a year. But it also has CN¥2.72b in cash to offset that, meaning it has CN¥754.0m net cash.

How Healthy Is NetDragon Websoft Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that NetDragon Websoft Holdings had liabilities of CN¥4.05b due within 12 months and liabilities of CN¥229.0m due beyond that. On the other hand, it had cash of CN¥2.72b and CN¥1.53b worth of receivables due within a year. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

This state of affairs indicates that NetDragon Websoft Holdings' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥4.85b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, NetDragon Websoft Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

Shareholders should be aware that NetDragon Websoft Holdings's EBIT was down 31% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 NetDragon Websoft 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 company can only pay off debt with cold hard cash, not accounting profits. While NetDragon Websoft 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 most recent three years, NetDragon Websoft Holdings recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that NetDragon Websoft Holdings has CN¥754.0m in net cash. So we don't have any problem with NetDragon Websoft Holdings's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for NetDragon Websoft Holdings you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.