We Think Formula Systems (1985) (TLV:FORTY) Can Stay On Top Of Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Formula Systems (1985) Ltd. (TLV:FORTY) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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)

How Much Debt Does Formula Systems (1985) Carry?

As you can see below, Formula Systems (1985) had US$653.1m of debt, at September 2022, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$508.4m, its net debt is less, at about US$144.7m.

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

Zooming in on the latest balance sheet data, we can see that Formula Systems (1985) had liabilities of US$916.7m due within 12 months and liabilities of US$628.9m due beyond that. On the other hand, it had cash of US$508.4m and US$739.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$297.6m.

This deficit isn't so bad because Formula Systems (1985) is worth US$996.5m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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 is only 0.44 times its EBITDA. And its EBIT easily covers its interest expense, being 28.2 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 22% 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 it is Formula Systems (1985)'s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. During the last three years, Formula Systems (1985) produced sturdy free cash flow equating to 73% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

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. Zooming out, Formula Systems (1985) seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Over time, share prices tend to follow earnings per share, so if you're interested in Formula Systems (1985), you may well want to click here to check an interactive graph of its earnings per share history.

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.