Here's Why SoftTech Engineers (NSE:SOFTTECH) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, SoftTech Engineers Limited (NSE:SOFTTECH) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for SoftTech Engineers

What Is SoftTech Engineers's Debt?

As you can see below, at the end of September 2020, SoftTech Engineers had ₹283.8m of debt, up from ₹145.3m a year ago. Click the image for more detail. However, it does have ₹85.8m in cash offsetting this, leading to net debt of about ₹198.0m.

How Healthy Is SoftTech Engineers's Balance Sheet?

We can see from the most recent balance sheet that SoftTech Engineers had liabilities of ₹204.4m falling due within a year, and liabilities of ₹182.8m due beyond that. Offsetting these obligations, it had cash of ₹85.8m as well as receivables valued at ₹680.2m due within 12 months. So it can boast ₹378.8m more liquid assets than total liabilities.

This surplus strongly suggests that SoftTech Engineers has a rock-solid balance sheet (and the debt is of no concern whatsoever). With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt sitting at just 1.3 times EBITDA, SoftTech Engineers is arguably pretty conservatively geared. And it boasts interest cover of 8.6 times, which is more than adequate. Also positive, SoftTech Engineers grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since SoftTech Engineers 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, SoftTech Engineers burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Happily, SoftTech Engineers's impressive EBIT growth rate implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Zooming out, SoftTech Engineers seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. Like risks, for instance. Every company has them, and we've spotted 4 warning signs for SoftTech Engineers (of which 2 are a bit unpleasant!) 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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