Is Hydsoft TechnologyLtd (SZSE:301316) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Hydsoft TechnologyLtd

How Much Debt Does Hydsoft TechnologyLtd Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Hydsoft TechnologyLtd had debt of CN¥155.5m, up from CN¥127.1m in one year. But on the other hand it also has CN¥284.4m in cash, leading to a CN¥128.9m net cash position.

How Strong Is Hydsoft TechnologyLtd's Balance Sheet?

The latest balance sheet data shows that Hydsoft TechnologyLtd had liabilities of CN¥348.9m due within a year, and liabilities of CN¥103.8m falling due after that. Offsetting this, it had CN¥284.4m in cash and CN¥669.6m in receivables that were due within 12 months. So it actually has CN¥501.3m more liquid assets than total liabilities.

This short term liquidity is a sign that Hydsoft TechnologyLtd could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Hydsoft TechnologyLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

On the other hand, Hydsoft TechnologyLtd's EBIT dived 17%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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. In the last three years, Hydsoft TechnologyLtd's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Hydsoft TechnologyLtd has CN¥128.9m in net cash and a decent-looking balance sheet. So we don't have any problem with Hydsoft TechnologyLtd's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Hydsoft TechnologyLtd (1 shouldn't be ignored!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.