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.' 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 Great Chinasoft Technology Co.,Ltd. (SZSE:002453) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 Great Chinasoft TechnologyLtd

What Is Great Chinasoft TechnologyLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Great Chinasoft TechnologyLtd had CN¥490.6m of debt in March 2022, down from CN¥692.7m, one year before. However, because it has a cash reserve of CN¥449.2m, its net debt is less, at about CN¥41.4m.

How Strong Is Great Chinasoft TechnologyLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Great Chinasoft TechnologyLtd had liabilities of CN¥1.31b due within 12 months and liabilities of CN¥38.4m due beyond that. On the other hand, it had cash of CN¥449.2m and CN¥881.3m worth of receivables due within a year. So these liquid assets roughly match the total liabilities.

Having regard to Great Chinasoft TechnologyLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥12.1b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Great Chinasoft TechnologyLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Great Chinasoft TechnologyLtd has a very low debt to EBITDA ratio of 0.29 so it is strange to see weak interest coverage, with last year's EBIT being only 2.3 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. If Great Chinasoft TechnologyLtd can keep growing EBIT at last year's rate of 12% over the last year, then it will find its debt load easier to manage. 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 Great Chinasoft TechnologyLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Great Chinasoft TechnologyLtd actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

The good news is that Great Chinasoft TechnologyLtd's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its interest cover. Zooming out, Great Chinasoft TechnologyLtd seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Great Chinasoft TechnologyLtd that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.