Here's Why Formula Systems (1985) (TLV:FORTY) Can Manage Its Debt Responsibly

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Formula Systems (1985) Ltd. (TLV:FORTY) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Formula Systems (1985)

What Is Formula Systems (1985)'s Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Formula Systems (1985) had US$552.3m of debt, an increase on US$487.6m, over one year. However, it also had US$435.8m in cash, and so its net debt is US$116.4m.

A Look At Formula Systems (1985)'s Liabilities

According to the last reported balance sheet, Formula Systems (1985) had liabilities of US$656.2m due within 12 months, and liabilities of US$622.3m due beyond 12 months. On the other hand, it had cash of US$435.8m and US$538.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$304.6m.

Formula Systems (1985) has a market capitalization of US$1.35b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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 0.53 times its EBITDA. And its EBIT easily covers its interest expense, being 10.1 times the size. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Formula Systems (1985) has been able to increase its EBIT by 21% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Formula Systems (1985)'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.

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. Looking at the most recent three years, Formula Systems (1985) recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Formula Systems (1985)'s net debt to EBITDA suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its interest cover also supports that impression! When we consider the range of factors above, it looks like Formula Systems (1985) is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Formula Systems (1985) has 2 warning signs (and 1 which shouldn't be ignored) we think you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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