These 4 Measures Indicate That SoftTech Engineers (NSE:SOFTTECH) Is Using Debt Reasonably Well

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 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 SoftTech Engineers Limited (NSE:SOFTTECH) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for SoftTech Engineers

What Is SoftTech Engineers's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 SoftTech Engineers had ₹283.8m of debt, an increase on ₹145.3m, over one year. However, it does have ₹85.8m in cash offsetting this, leading to net debt of about ₹198.0m.

How Strong Is SoftTech Engineers' Balance Sheet?

According to the last reported balance sheet, SoftTech Engineers had liabilities of ₹204.4m due within 12 months, and liabilities of ₹182.8m due beyond 12 months. On the other hand, it had cash of ₹85.8m and ₹680.2m worth of receivables due within a year. So it actually has ₹378.8m more liquid assets than total liabilities.

This surplus liquidity suggests that SoftTech Engineers' balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master.

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).

With net debt sitting at just 1.3 times EBITDA, SoftTech Engineers is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.6 times the interest expense over the last year. 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. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, SoftTech Engineers 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

SoftTech Engineers's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at the bigger picture, we think SoftTech Engineers's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for SoftTech Engineers (2 are potentially serious!) that you should be aware of before investing here.

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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