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 Chinasoft International Limited (HKG:354) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Chinasoft International Carry?

The image below, which you can click on for greater detail, shows that Chinasoft International had debt of CN¥3.61b at the end of June 2024, a reduction from CN¥4.06b over a year. However, because it has a cash reserve of CN¥2.94b, its net debt is less, at about CN¥668.7m.

A Look At Chinasoft International's Liabilities

According to the last reported balance sheet, Chinasoft International had liabilities of CN¥4.10b due within 12 months, and liabilities of CN¥1.70b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.94b as well as receivables valued at CN¥8.61b due within 12 months. So it can boast CN¥5.74b more liquid assets than total liabilities.

This surplus strongly suggests that Chinasoft International has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, lenders should feel as safe as the beloved of a black-belt karate master.

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.

Looking at its net debt to EBITDA of 1.2 and interest cover of 6.9 times, it seems to us that Chinasoft International is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. But the other side of the story is that Chinasoft International saw its EBIT decline by 3.3% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Chinasoft International'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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Chinasoft International produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Chinasoft International's demonstrated ability to handle its total liabilities delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its EBIT growth rate. Zooming out, Chinasoft International seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Chinasoft International you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.