Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We note that Jiangsu Hoperun Software Co., Ltd. (SZSE:300339) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Jiangsu Hoperun Software Carry?

You can click the graphic below for the historical numbers, but it shows that Jiangsu Hoperun Software had CN¥673.9m of debt in March 2024, down from CN¥779.0m, one year before. However, because it has a cash reserve of CN¥473.1m, its net debt is less, at about CN¥200.8m.

How Strong Is Jiangsu Hoperun Software's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Jiangsu Hoperun Software had liabilities of CN¥1.14b due within 12 months and liabilities of CN¥425.7m due beyond that. On the other hand, it had cash of CN¥473.1m and CN¥1.85b worth of receivables due within a year. So it can boast CN¥751.8m more liquid assets than total liabilities.

This short term liquidity is a sign that Jiangsu Hoperun Software could probably pay off its debt with ease, as its balance sheet is far from stretched. But either way, Jiangsu Hoperun Software has virtually no net debt, so it's fair to say it does not have a heavy debt load!

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Jiangsu Hoperun Software has a low net debt to EBITDA ratio of only 1.5. And its EBIT easily covers its interest expense, being 11.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Jiangsu Hoperun Software grew its EBIT by 248% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Jiangsu Hoperun Software's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Jiangsu Hoperun Software's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Jiangsu Hoperun Software's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at the bigger picture, we think Jiangsu Hoperun Software's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. Case in point: We've spotted 1 warning sign for Jiangsu Hoperun Software you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.

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