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

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.' 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. As with many other companies Hydsoft Technology Co.,Ltd. (SZSE:301316) makes use of debt. But the real question is whether this debt is making the company risky.

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When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Hydsoft TechnologyLtd's Debt?

As you can see below, at the end of September 2024, Hydsoft TechnologyLtd had CN¥254.3m of debt, up from CN¥128.8m a year ago. Click the image for more detail. But it also has CN¥272.0m in cash to offset that, meaning it has CN¥17.7m net cash.

A Look At Hydsoft TechnologyLtd's Liabilities

We can see from the most recent balance sheet that Hydsoft TechnologyLtd had liabilities of CN¥443.5m falling due within a year, and liabilities of CN¥113.1m due beyond that. Offsetting these obligations, it had cash of CN¥272.0m as well as receivables valued at CN¥689.5m due within 12 months. So it can boast CN¥404.9m 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.

See our latest analysis for Hydsoft TechnologyLtd

On the other hand, Hydsoft TechnologyLtd saw its EBIT drop by 7.2% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Finally, while the tax-man may adore accounting profits, lenders only accept 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 created free cash flow amounting to 3.5% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Hydsoft TechnologyLtd has net cash of CN¥17.7m, as well as more liquid assets than liabilities. So we don't have any problem with Hydsoft TechnologyLtd's use of debt. 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. For example, we've discovered 1 warning sign for Hydsoft TechnologyLtd that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.