Megasoft (NSE:MEGASOFT) Seems To Be Using A Lot Of Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Megasoft Limited (NSE:MEGASOFT) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its 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 ₹348.2m of debt in September 2020, down from ₹397.3m, one year before. On the flip side, it has ₹66.9m in cash leading to net debt of about ₹281.3m.

How Healthy Is Megasoft's Balance Sheet?

According to the last reported balance sheet, Megasoft had liabilities of ₹1.67b due within 12 months, and liabilities of ₹215.0m due beyond 12 months. Offsetting these obligations, it had cash of ₹66.9m as well as receivables valued at ₹499.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.32b.

The deficiency here weighs heavily on the ₹512.2m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Megasoft shareholders face the double whammy of a high net debt to EBITDA ratio (8.6), and fairly weak interest coverage, since EBIT is just 0.19 times the interest expense. The debt burden here is substantial. However, the silver lining was that Megasoft achieved a positive EBIT of ₹9.6m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Megasoft 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Megasoft burned a lot of cash. 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 at least its EBIT growth rate is not so bad. Considering all the factors previously mentioned, we think that Megasoft really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with Megasoft (including 1 which shouldn't be ignored) .

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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