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.' 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 GK Software SE (ETR:GKS) does use debt in its business. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for GK Software
What Is GK Software's Net Debt?
As you can see below, GK Software had €25.8m of debt at June 2020, down from €34.0m a year prior. On the flip side, it has €11.3m in cash leading to net debt of about €14.5m.
How Healthy Is GK Software's Balance Sheet?
We can see from the most recent balance sheet that GK Software had liabilities of €34.1m falling due within a year, and liabilities of €30.8m due beyond that. Offsetting this, it had €11.3m in cash and €39.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €14.3m.
Since publicly traded GK Software shares are worth a total of €181.1m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While GK Software's low debt to EBITDA ratio of 0.92 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.3 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that GK Software improved its EBIT from a last year's loss to a positive €10m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if GK Software 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, GK Software actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our View
GK Software's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its interest cover. Taking all this data into account, it seems to us that GK Software takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. Take risks, for example - GK Software has 2 warning signs we think you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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. 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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About XTRA:GKS
Reasonable growth potential with adequate balance sheet.
