Formula Systems (1985) (TLV:FORTY) Seems To Use Debt Quite Sensibly

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. We note that Formula Systems (1985) Ltd. (TLV:FORTY) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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, 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 Formula Systems (1985)

What Is Formula Systems (1985)'s Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Formula Systems (1985) had debt of US$647.7m, up from US$586.4m in one year. On the flip side, it has US$569.1m in cash leading to net debt of about US$78.6m.

How Healthy Is Formula Systems (1985)'s Balance Sheet?

The latest balance sheet data shows that Formula Systems (1985) had liabilities of US$1.00b due within a year, and liabilities of US$616.0m falling due after that. On the other hand, it had cash of US$569.1m and US$725.1m worth of receivables due within a year. So its liabilities total US$322.9m more than the combination of its cash and short-term receivables.

Formula Systems (1985) has a market capitalization of US$1.12b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Formula Systems (1985)'s net debt is only 0.28 times its EBITDA. And its EBIT easily covers its interest expense, being 18.4 times the size. So we're pretty relaxed about its super-conservative use of debt. Also good is that Formula Systems (1985) grew its EBIT at 12% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Formula Systems (1985) will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Formula Systems (1985) 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

The good news is that Formula Systems (1985)'s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think Formula Systems (1985)'s use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. We've identified 1 warning sign with Formula Systems (1985) , and understanding them should be part of your investment process.

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. 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.