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.' 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 note that Formula Systems (1985) Ltd. (TLV:FORTY) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

See our latest analysis for Formula Systems (1985)

What Is Formula Systems (1985)'s Debt?

As you can see below, at the end of June 2023, Formula Systems (1985) had US$605.5m of debt, up from US$560.3m a year ago. Click the image for more detail. On the flip side, it has US$477.5m in cash leading to net debt of about US$128.0m.

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

We can see from the most recent balance sheet that Formula Systems (1985) had liabilities of US$924.0m falling due within a year, and liabilities of US$574.8m due beyond that. Offsetting this, it had US$477.5m in cash and US$698.1m in receivables that were due within 12 months. So its liabilities total US$323.1m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Formula Systems (1985) has a market capitalization of US$993.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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 is only 0.45 times its EBITDA. And its EBIT easily covers its interest expense, being 14.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Formula Systems (1985) grew its EBIT by 3.9% in the last year, making that debt load look even more manageable. 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 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Formula Systems (1985) recorded free cash flow worth 62% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Formula Systems (1985)'s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! All these things considered, it appears that Formula Systems (1985) can comfortably handle its current debt levels. 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. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Formula Systems (1985)'s earnings per share history for free.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.