Is Chinasoft International (HKG:354) 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.' 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 can see that Chinasoft International Limited (HKG:354) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Chinasoft International

What Is Chinasoft International's Debt?

The chart below, which you can click on for greater detail, shows that Chinasoft International had CN¥2.61b in debt in June 2022; about the same as the year before. However, it does have CN¥4.79b in cash offsetting this, leading to net cash of CN¥2.18b.

How Healthy Is Chinasoft International's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chinasoft International had liabilities of CN¥5.20b due within 12 months and liabilities of CN¥214.9m due beyond that. Offsetting this, it had CN¥4.79b in cash and CN¥8.32b in receivables that were due within 12 months. So it can boast CN¥7.70b more liquid assets than total liabilities.

This surplus strongly suggests that Chinasoft International has a rock-solid balance sheet (and the debt is of no concern whatsoever). With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that Chinasoft International has more cash than debt is arguably a good indication that it can manage its debt safely.

But the other side of the story is that Chinasoft International saw its EBIT decline by 9.1% over the last year. 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 ultimately the future profitability of the business will decide if Chinasoft International can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Chinasoft International 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, Chinasoft International produced sturdy free cash flow equating to 72% 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 Chinasoft International has CN¥2.18b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥331m, being 72% of its EBIT. So we don't think Chinasoft International's use of debt is risky. We'd be very excited to see if Chinasoft International insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.

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.