Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Hydsoft Technology Co.,Ltd. (SZSE:301316) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Hydsoft TechnologyLtd's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Hydsoft TechnologyLtd had debt of CN¥113.3m, up from CN¥68.4m in one year. However, its balance sheet shows it holds CN¥304.9m in cash, so it actually has CN¥191.6m net cash.

How Healthy Is Hydsoft TechnologyLtd's Balance Sheet?

According to the last reported balance sheet, Hydsoft TechnologyLtd had liabilities of CN¥293.4m due within 12 months, and liabilities of CN¥95.1m due beyond 12 months. Offsetting these obligations, it had cash of CN¥304.9m as well as receivables valued at CN¥610.2m due within 12 months. So it can boast CN¥526.7m 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. Succinctly put, Hydsoft TechnologyLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

Fortunately, Hydsoft TechnologyLtd grew its EBIT by 6.3% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hydsoft TechnologyLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Hydsoft TechnologyLtd 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 last three years, Hydsoft TechnologyLtd reported free cash flow worth 16% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Hydsoft TechnologyLtd has CN¥191.6m in net cash and a decent-looking balance sheet. And it also grew its EBIT by 6.3% over the last year. So we are not troubled with Hydsoft TechnologyLtd's debt use. 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 1 warning sign for Hydsoft TechnologyLtd you should know about.

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.