Legendary fund manager Li Lu (who was assisted by Charlie Munger) once said: “The greatest risk to investment is not price volatility, but whether you experience permanent capital loss.” So it might be obvious that you need to consider debt when thinking about how risky a particular stock is, as too much debt can cause a company to decline. We make a note of that SoftTech Engineers Limited (NSE: SOFTTECH) has debt on its balance sheet. But the more important question is: what is the risk this debt creates?
When is debt dangerous?
Debt and other liabilities become risky for a company when it cannot meet those obligations easily, either with free cash flow or by raising capital at an attractive price. When things get really bad, lenders can take control of the business. However, a more common (but still costly) occurrence is when a company has to issue stocks at bargain prices, which permanently dilutes shareholders just to prop up its balance sheet. However, by replacing the dilution, debt can be an extremely good tool for companies that need capital to invest in growth with high returns. When we think about using a company’s debt, let’s first look at cash and debt together.
What is the net debt of SoftTech Engineers?
You can click the graph below to view the historical numbers, but it shows that SoftTech Engineers had 283.8 million in debt as of September 2020, up from 145.3 million in a year. However, this is offset by 85.8 million in cash, which leads to a net debt of approx. 198.0 million.
How strong is the bottom line of SoftTech Engineers?
According to the most recently published balance sheet, SoftTech Engineers had liabilities of 204.4 million due within 12 months and liabilities of 182.8 million due beyond 12 months. On the other hand, it had liquid funds of 85.8 million and receivables due within one year of 680.2 million. So it actually has ₹ 378.8m more cash than total liabilities.
This excess liquidity suggests that SoftTech Engineers’ balance sheets could be just as badly damaged as Homer Simpson’s head. From this point of view, lenders should feel as safe as the lovers of a black belted karate master.
We use two main metrics to help us understand debt versus revenue. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), and the second is how often earnings before interest and taxes (EBIT) cover its interest expense (or interest coverage for short). . The advantage of this approach is that we take into account both the absolute level of debt (with net debt to EBITDA) and the actual interest expenses associated with this debt (with its interest coverage ratio).
With a net debt of only 1.3 times EBITDA, SoftTech Engineers is arguably quite conservative. This assessment is supported by the solid interest coverage, the EBIT of which was 8.6 times the interest expense of the previous year. It is also positive that SoftTech Engineers increased its EBIT by 29% last year, which should make it easier to repay debt in the future. The balance sheet is clearly the area to focus on when analyzing debt. But you can’t look at debt in complete isolation; because SoftTech engineers need revenue to service this debt. So when looking at debt, it’s definitely worth taking a look at earnings trends. Click here for an interactive snapshot.
But our final consideration is also important because a company cannot pay its debts with paper profits; it takes cold cash. So the logical step is to look at the portion of this EBIT that corresponds to the actual free cash flow. SoftTech Engineers have burned a lot of money over the past three years. While investors no doubt expect this situation to reverse in due course, it clearly means that using debt is riskier.
SoftTech Engineers’ EBIT growth rate suggests the company can manage its debt as easily as Cristiano Ronaldo could score against a goalkeeper under the age of 14. But the bare truth is that we’re worried about converting EBIT to free cash flow. When we look at the bigger picture, we find SoftTech Engineers’ use of debt to be quite reasonable and not to worry about it. Debt carries risks, but if used carefully, it can also result in a higher return on equity. Undoubtedly, we learn the most about balance sheet debt. But ultimately, any business can involve off-balance sheet risks. For example we discovered 3 warning signs for SoftTech engineers (2 are potentially serious!) That you should know before investing here.
After all that, if you’re more interested in a fast-growing company with a rock-solid balance sheet, then drop by our list of net cash growth stocks without delay.
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