DHC SoftwareLtd (SZSE:002065) Has A Pretty Healthy Balance Sheet

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, DHC Software Co.,Ltd. (SZSE:002065) does carry debt. But the real question is whether this debt is making the company risky.

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for DHC SoftwareLtd

How Much Debt Does DHC SoftwareLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2024 DHC SoftwareLtd had debt of CN¥5.39b, up from CN¥4.50b in one year. On the flip side, it has CN¥1.01b in cash leading to net debt of about CN¥4.38b.

How Strong Is DHC SoftwareLtd's Balance Sheet?

The latest balance sheet data shows that DHC SoftwareLtd had liabilities of CN¥12.0b due within a year, and liabilities of CN¥167.4m falling due after that. Offsetting these obligations, it had cash of CN¥1.01b as well as receivables valued at CN¥8.32b due within 12 months. So it has liabilities totalling CN¥2.85b more than its cash and near-term receivables, combined.

Given DHC SoftwareLtd has a market capitalization of CN¥21.4b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

As it happens DHC SoftwareLtd has a fairly concerning net debt to EBITDA ratio of 6.3 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! It is well worth noting that DHC SoftwareLtd's EBIT shot up like bamboo after rain, gaining 69% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since DHC SoftwareLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, DHC SoftwareLtd 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.

Our View

DHC SoftwareLtd's conversion of EBIT to free cash flow was a real negative on this analysis, as was its net debt to EBITDA. But its interest cover was significantly redeeming. Looking at all this data makes us feel a little cautious about DHC SoftwareLtd's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should learn about the 3 warning signs we've spotted with DHC SoftwareLtd (including 1 which is significant) .

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.