Is Converge Technology Solutions (TSE:CTS) Using Too Much Debt?

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. We can see that Converge Technology Solutions Corp. (TSE:CTS) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Converge Technology Solutions

What Is Converge Technology Solutions's Debt?

As you can see below, Converge Technology Solutions had CA$331.7m of debt at June 2024, down from CA$432.1m a year prior. However, it also had CA$173.8m in cash, and so its net debt is CA$157.9m.

How Strong Is Converge Technology Solutions' Balance Sheet?

We can see from the most recent balance sheet that Converge Technology Solutions had liabilities of CA$1.17b falling due within a year, and liabilities of CA$514.2m due beyond that. Offsetting these obligations, it had cash of CA$173.8m as well as receivables valued at CA$882.4m due within 12 months. So it has liabilities totalling CA$624.7m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CA$884.0m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 1.0 times EBITDA, it is initially surprising to see that Converge Technology Solutions's EBIT has low interest coverage of 1.4 times. So one way or the other, it's clear the debt levels are not trivial. One way Converge Technology Solutions could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Converge Technology Solutions 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Converge Technology Solutions actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On our analysis Converge Technology Solutions's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. When we consider all the elements mentioned above, it seems to us that Converge Technology Solutions is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Converge Technology Solutions you should know about.

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.

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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.