Is NetDragon Websoft Holdings (HKG:777) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies NetDragon Websoft Holdings Limited (HKG:777) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for NetDragon Websoft Holdings

What Is NetDragon Websoft Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 NetDragon Websoft Holdings had CN¥1.49b of debt, an increase on CN¥1.34b, over one year. However, it does have CN¥4.35b in cash offsetting this, leading to net cash of CN¥2.86b.

How Strong Is NetDragon Websoft Holdings' Balance Sheet?

According to the last reported balance sheet, NetDragon Websoft Holdings had liabilities of CN¥2.55b due within 12 months, and liabilities of CN¥1.26b due beyond 12 months. Offsetting this, it had CN¥4.35b in cash and CN¥1.38b in receivables that were due within 12 months. So it can boast CN¥1.91b more liquid assets than total liabilities.

This excess liquidity suggests that NetDragon Websoft Holdings is taking a careful approach to debt. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that NetDragon Websoft Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

Also good is that NetDragon Websoft Holdings grew its EBIT at 16% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if NetDragon Websoft Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While NetDragon Websoft Holdings 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 most recent three years, NetDragon Websoft Holdings recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that NetDragon Websoft Holdings has net cash of CN¥2.86b, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 16% over the last year. So we don't think NetDragon Websoft Holdings's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for NetDragon Websoft Holdings 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.