The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 note that Great Chinasoft Technology Co.,Ltd. (SZSE:002453) 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Great Chinasoft TechnologyLtd

How Much Debt Does Great Chinasoft TechnologyLtd Carry?

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, it does have CN¥449.2m in cash offsetting this, leading to net debt of about CN¥41.4m.

How Strong Is Great Chinasoft TechnologyLtd's Balance Sheet?

According to the last reported balance sheet, Great Chinasoft TechnologyLtd had liabilities of CN¥1.31b due within 12 months, and liabilities of CN¥38.4m due beyond 12 months. Offsetting these obligations, it had cash of CN¥449.2m as well as receivables valued at CN¥881.3m due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

Having regard to Great Chinasoft TechnologyLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥10.8b company is short on cash, but still worth keeping an eye on the 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!

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Given net debt is only 0.29 times EBITDA, it is initially surprising to see that Great Chinasoft TechnologyLtd's EBIT has low interest coverage of 2.3 times. So one way or the other, it's clear the debt levels are not 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. There's no doubt that we learn most about debt from the balance sheet. But it is Great Chinasoft TechnologyLtd's earnings that will influence how the balance sheet holds up in the future. 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 always check how much of that EBIT is translated into 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 generation warms our hearts like a puppy in a bumblebee suit.

Our View

Happily, Great Chinasoft TechnologyLtd's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its interest cover has the opposite effect. Looking at the bigger picture, we think Great Chinasoft TechnologyLtd's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. There's no doubt that we learn most about debt from the balance sheet. 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.

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.