These 4 Measures Indicate That NetDragon Websoft Holdings (HKG:777) Is Using Debt Reasonably Well

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 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 NetDragon Websoft Holdings Limited (HKG:777) does use debt in its business. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for NetDragon Websoft Holdings

How Much Debt Does NetDragon Websoft Holdings Carry?

As you can see below, at the end of June 2023, NetDragon Websoft Holdings had CN¥2.41b of debt, up from CN¥1.65b a year ago. Click the image for more detail. However, it does have CN¥4.27b in cash offsetting this, leading to net cash of CN¥1.85b.

How Healthy Is NetDragon Websoft Holdings' Balance Sheet?

According to the last reported balance sheet, NetDragon Websoft Holdings had liabilities of CN¥3.15b due within 12 months, and liabilities of CN¥1.58b due beyond 12 months. Offsetting this, it had CN¥4.27b in cash and CN¥1.48b in receivables that were due within 12 months. So it can boast CN¥1.00b more liquid assets than total liabilities.

This surplus suggests that NetDragon Websoft Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. 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.

Importantly, NetDragon Websoft Holdings's EBIT fell a jaw-dropping 30% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine NetDragon Websoft Holdings'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, a company can only pay off debt with cold hard cash, not accounting profits. NetDragon Websoft Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, NetDragon Websoft Holdings produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to investigate a company's debt, in this case NetDragon Websoft Holdings has CN¥1.85b in net cash and a decent-looking balance sheet. So we are not troubled with NetDragon Websoft Holdings's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with NetDragon Websoft Holdings , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.