Is ReadyTech Holdings (ASX:RDY) Using Too Much Debt?

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies ReadyTech Holdings Limited (ASX:RDY) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for ReadyTech Holdings

How Much Debt Does ReadyTech Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 ReadyTech Holdings had AU$30.9m of debt, an increase on AU$25.0m, over one year. On the flip side, it has AU$12.0m in cash leading to net debt of about AU$18.9m.

How Healthy Is ReadyTech Holdings' Balance Sheet?

According to the last reported balance sheet, ReadyTech Holdings had liabilities of AU$44.6m due within 12 months, and liabilities of AU$49.9m due beyond 12 months. On the other hand, it had cash of AU$12.0m and AU$8.59m worth of receivables due within a year. So it has liabilities totalling AU$73.9m more than its cash and near-term receivables, combined.

Since publicly traded ReadyTech Holdings shares are worth a total of AU$448.4m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

ReadyTech Holdings's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 5.8 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably ReadyTech Holdings's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ReadyTech Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the last two years, ReadyTech Holdings actually produced more free cash flow than EBIT. 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 ReadyTech Holdings's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And its level of total liabilities is good too. Looking at all the aforementioned factors together, it strikes us that ReadyTech Holdings can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. To that end, you should be aware of the 5 warning signs we've spotted with ReadyTech Holdings .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.

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