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

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 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?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

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 2020 Formula Systems (1985) had debt of US$545.3m, up from US$494.1m in one year. On the flip side, it has US$533.2m in cash leading to net debt of about US$12.1m.

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

According to the last reported balance sheet, Formula Systems (1985) had liabilities of US$779.8m due within 12 months, and liabilities of US$632.7m due beyond 12 months. On the other hand, it had cash of US$533.2m and US$603.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$275.6m.

Of course, Formula Systems (1985) has a market capitalization of US$1.47b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. But either way, Formula Systems (1985) has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Formula Systems (1985)'s net debt to EBITDA ratio is very low, at 0.054, suggesting the debt is only trivial. But EBIT was only 6.3 times the interest expense last year, so the borrowing is clearly weighing on the business somewhat. Another good sign is that Formula Systems (1985) has been able to increase its EBIT by 23% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Formula Systems (1985) will need earnings to service that debt. 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. 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) reported free cash flow worth 15% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Happily, Formula Systems (1985)'s impressive net debt to EBITDA implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Formula Systems (1985) can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. To that end, you should learn about the 2 warning signs we've spotted with Formula Systems (1985) (including 1 which is significant) .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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