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. Importantly, Perfect World Co., Ltd. (SZSE:002624) does carry debt. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Perfect World's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Perfect World had CN¥540.6m of debt, an increase on CN¥450.9m, over one year. However, its balance sheet shows it holds CN¥4.43b in cash, so it actually has CN¥3.89b net cash.

How Strong Is Perfect World's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Perfect World had liabilities of CN¥3.74b due within 12 months and liabilities of CN¥1.55b due beyond that. Offsetting these obligations, it had cash of CN¥4.43b as well as receivables valued at CN¥1.03b due within 12 months. So it actually has CN¥158.6m more liquid assets than total liabilities.

This state of affairs indicates that Perfect World's 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¥18.2b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Perfect World has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Perfect World's load is not too heavy, because its EBIT was down 93% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Perfect World'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Perfect World 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. During the last three years, Perfect World generated free cash flow amounting to a very robust 91% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Perfect World has net cash of CN¥3.89b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of -CN¥4.4m, being 91% of its EBIT. So we don't have any problem with Perfect World's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Perfect World (including 1 which shouldn't be ignored) .

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.