Chinasoft International (HKG:354) Seems To Use Debt Rather Sparingly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Chinasoft International Limited (HKG:354) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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.

Check out our latest analysis for Chinasoft International

What Is Chinasoft International's Net Debt?

As you can see below, Chinasoft International had CN¥1.80b of debt at December 2020, down from CN¥2.47b a year prior. But on the other hand it also has CN¥3.79b in cash, leading to a CN¥1.99b net cash position.

How Strong Is Chinasoft International's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chinasoft International had liabilities of CN¥2.72b due within 12 months and liabilities of CN¥1.59b due beyond that. On the other hand, it had cash of CN¥3.79b and CN¥6.54b worth of receivables due within a year. So it can boast CN¥6.02b more liquid assets than total liabilities.

This luscious liquidity implies that Chinasoft International's balance sheet is sturdy like a giant sequoia tree. Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that Chinasoft International has more cash than debt is arguably a good indication that it can manage its debt safely.

In addition to that, we're happy to report that Chinasoft International has boosted its EBIT by 32%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Chinasoft International'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Chinasoft International 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, Chinasoft International's free cash flow amounted to 21% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Chinasoft International has net cash of CN¥1.99b, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 32% over the last year. So is Chinasoft International's debt a risk? It doesn't seem so to us. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Chinasoft International you should know about.

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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