Stock Analysis

These 4 Measures Indicate That GK Software (ETR:GKS) Is Using Debt Reasonably Well


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.' 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. Importantly, GK Software SE (ETR:GKS) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.

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How Much Debt Does GK Software Carry?

You can click the graphic below for the historical numbers, but it shows that GK Software had €17.1m of debt in September 2022, down from €19.2m, one year before. However, its balance sheet shows it holds €63.3m in cash, so it actually has €46.2m net cash.

XTRA:GKS Debt to Equity History March 2nd 2023

How Strong Is GK Software's Balance Sheet?

We can see from the most recent balance sheet that GK Software had liabilities of €50.2m falling due within a year, and liabilities of €14.4m due beyond that. Offsetting these obligations, it had cash of €63.3m as well as receivables valued at €43.5m due within 12 months. So it actually has €42.1m more liquid assets than total liabilities.

This surplus suggests that GK Software has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, GK Software boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that GK Software has seen its EBIT plunge 12% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 GK Software's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While GK Software 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. Happily for any shareholders, GK Software actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While it is always sensible to investigate a company's debt, in this case GK Software has €46.2m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 103% of that EBIT to free cash flow, bringing in €22m. So we don't think GK Software's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for GK Software 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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