Is Cambridge Technology Enterprises (NSE:CTE) Using Too Much Debt?

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.' 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 Cambridge Technology Enterprises Limited (NSE:CTE) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

View our latest analysis for Cambridge Technology Enterprises

How Much Debt Does Cambridge Technology Enterprises Carry?

As you can see below, at the end of March 2024, Cambridge Technology Enterprises had ₹1.16b of debt, up from ₹568.1m a year ago. Click the image for more detail. However, it also had ₹549.7m in cash, and so its net debt is ₹614.7m.

How Healthy Is Cambridge Technology Enterprises' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cambridge Technology Enterprises had liabilities of ₹895.2m due within 12 months and liabilities of ₹705.1m due beyond that. On the other hand, it had cash of ₹549.7m and ₹596.4m worth of receivables due within a year. So its liabilities total ₹454.2m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Cambridge Technology Enterprises has a market capitalization of ₹2.08b, 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 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.

Even though Cambridge Technology Enterprises's debt is only 2.3, its interest cover is really very low at 1.9. This does have us wondering if the company pays high interest because it is considered risky. In any case, it's safe to say the company has meaningful debt. It is well worth noting that Cambridge Technology Enterprises's EBIT shot up like bamboo after rain, gaining 43% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Cambridge Technology Enterprises 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Cambridge Technology Enterprises saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Neither Cambridge Technology Enterprises's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that Cambridge Technology Enterprises's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example Cambridge Technology Enterprises has 6 warning signs (and 2 which are a bit concerning) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.

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