Is Sonata Software (NSE:SONATSOFTW) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that Sonata Software Limited (NSE:SONATSOFTW) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

Check out our latest analysis for Sonata Software

How Much Debt Does Sonata Software Carry?

The image below, which you can click on for greater detail, shows that Sonata Software had debt of ₹380.0m at the end of March 2022, a reduction from ₹897.3m over a year. But on the other hand it also has ₹9.14b in cash, leading to a ₹8.76b net cash position.

How Strong Is Sonata Software's Balance Sheet?

According to the last reported balance sheet, Sonata Software had liabilities of ₹12.9b due within 12 months, and liabilities of ₹1.66b due beyond 12 months. Offsetting these obligations, it had cash of ₹9.14b as well as receivables valued at ₹8.93b due within 12 months. So it actually has ₹3.51b more liquid assets than total liabilities.

This short term liquidity is a sign that Sonata Software could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Sonata Software has more cash than debt is arguably a good indication that it can manage its debt safely.

Another good sign is that Sonata Software has been able to increase its EBIT by 29% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Sonata Software's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Sonata Software has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Sonata Software actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While it is always sensible to investigate a company's debt, in this case Sonata Software has ₹8.76b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of ₹4.8b, being 112% of its EBIT. So is Sonata Software's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Sonata Software you should know about.

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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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.