Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk’. 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 Softing AG (ETR:SYT) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Softing’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Softing had debt of €14.5m, up from €9.32m in one year. But on the other hand it also has €15.0m in cash, leading to a €505.0k net cash position.
How Strong Is Softing’s Balance Sheet?
According to the last reported balance sheet, Softing had liabilities of €17.6m due within 12 months, and liabilities of €24.9m due beyond 12 months. Offsetting these obligations, it had cash of €15.0m as well as receivables valued at €13.9m due within 12 months. So its liabilities total €13.6m more than the combination of its cash and short-term receivables.
Softing has a market capitalization of €64.3m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Softing boasts net cash, so it’s fair to say it does not have a heavy debt load!
Also positive, Softing grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Softing’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Softing has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Softing generated free cash flow amounting to a very robust 86% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
While Softing does have more liabilities than liquid assets, it also has net cash of €505.0k. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in €7.0m. So we don’t think Softing’s use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 4 warning signs for Softing that you should be aware of before investing here.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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