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.' 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. As with many other companies NetDragon Websoft Holdings Limited (HKG:777) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for NetDragon Websoft Holdings

What Is NetDragon Websoft Holdings's Debt?

As you can see below, at the end of June 2022, NetDragon Websoft Holdings had CN¥1.65b of debt, up from CN¥1.33b a year ago. Click the image for more detail. But on the other hand it also has CN¥3.90b in cash, leading to a CN¥2.25b net cash position.

How Healthy Is NetDragon Websoft Holdings' Balance Sheet?

According to the last reported balance sheet, NetDragon Websoft Holdings had liabilities of CN¥2.66b due within 12 months, and liabilities of CN¥1.36b due beyond 12 months. On the other hand, it had cash of CN¥3.90b and CN¥1.44b worth of receivables due within a year. So it actually has CN¥1.32b more liquid assets than total liabilities.

It's good to see that NetDragon Websoft Holdings has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. 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.

NetDragon Websoft Holdings's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. There's no doubt that we learn most about debt from the balance sheet. 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. 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 59% 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 we empathize with investors who find debt concerning, you should keep in mind that NetDragon Websoft Holdings has net cash of CN¥2.25b, as well as more liquid assets than liabilities. So we don't think NetDragon Websoft Holdings's use of debt is risky. 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. For example - NetDragon Websoft Holdings has 2 warning signs we think you should be aware of.

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.