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. As with many other companies Digiwin Co., Ltd. (SZSE:300378) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Digiwin Carry?

As you can see below, at the end of September 2024, Digiwin had CN¥78.7m of debt, up from CN¥75.5m a year ago. Click the image for more detail. But on the other hand it also has CN¥621.1m in cash, leading to a CN¥542.4m net cash position.

How Strong Is Digiwin's Balance Sheet?

The latest balance sheet data shows that Digiwin had liabilities of CN¥802.4m due within a year, and liabilities of CN¥61.1m falling due after that. Offsetting these obligations, it had cash of CN¥621.1m as well as receivables valued at CN¥678.6m due within 12 months. So it actually has CN¥436.2m more liquid assets than total liabilities.

This short term liquidity is a sign that Digiwin could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Digiwin boasts net cash, so it's fair to say it does not have a heavy debt load!

And we also note warmly that Digiwin grew its EBIT by 16% last year, making its debt load easier to handle. 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 Digiwin'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Digiwin 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, Digiwin saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Digiwin has net cash of CN¥542.4m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 16% over the last year. So we are not troubled with Digiwin'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. We've identified 2 warning signs with Digiwin , and understanding them should be part of your investment process.

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.