Megasoft (NSE:MEGASOFT) Has A Somewhat Strained Balance Sheet

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Megasoft Limited (NSE:MEGASOFT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Megasoft

How Much Debt Does Megasoft Carry?

You can click the graphic below for the historical numbers, but it shows that Megasoft had ₹290.1m of debt in March 2021, down from ₹396.5m, one year before. However, because it has a cash reserve of ₹72.4m, its net debt is less, at about ₹217.7m.

A Look At Megasoft's Liabilities

According to the last reported balance sheet, Megasoft had liabilities of ₹1.55b due within 12 months, and liabilities of ₹210.7m due beyond 12 months. Offsetting this, it had ₹72.4m in cash and ₹450.2m in receivables that were due within 12 months. So it has liabilities totalling ₹1.23b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the ₹539.2m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Megasoft would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Even though Megasoft's debt is only 2.0, its interest cover is really very low at 1.3. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Notably, Megasoft's EBIT launched higher than Elon Musk, gaining a whopping 637% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is Megasoft'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Megasoft 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

On the face of it, Megasoft's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Megasoft's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Megasoft .

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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