David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ 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 esoft systems A/S (CPH:ESOFT) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is esoft systems’s Debt?
The image below, which you can click on for greater detail, shows that at December 2018 esoft systems had debt of ø28.0k, up from none in one year. But it also has ø21.2m in cash to offset that, meaning it has ø21.2m net cash.
How Strong Is esoft systems’s Balance Sheet?
According to the last reported balance sheet, esoft systems had liabilities of ø5.39m due within 12 months, and liabilities of ø13.8m due beyond 12 months. Offsetting these obligations, it had cash of ø21.2m as well as receivables valued at ø16.4m due within 12 months. So it can boast ø18.4m more liquid assets than total liabilities.
This excess liquidity is a great indication that esoft systems’s balance sheet is just as strong as racists are weak. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Succinctly put, esoft systems boasts net cash, so it’s fair to say it does not have a heavy debt load!
It is just as well that esoft systems’s load is not too heavy, because its EBIT was down 98% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is esoft systems’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While esoft systems 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, esoft systems 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.
While we empathize with investors who find debt concerning, you should keep in mind that esoft systems has net cash of ø21m, as well as more liquid assets than liabilities. The cherry on top was that in converted 102% of that EBIT to free cash flow, bringing in -ø695.0k. So is esoft systems’s debt a risk? It doesn’t seem so to us. Given esoft systems has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.