Does Tera Software (NSE:TERASOFT) Have A Healthy Balance Sheet?

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.' 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. Importantly, Tera Software Limited (NSE:TERASOFT) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 Tera Software

What Is Tera Software's Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Tera Software had debt of ₹546.1m, up from ₹294.8m in one year. However, because it has a cash reserve of ₹137.7m, its net debt is less, at about ₹408.4m.

A Look At Tera Software's Liabilities

The latest balance sheet data shows that Tera Software had liabilities of ₹1.85b due within a year, and liabilities of ₹51.0m falling due after that. On the other hand, it had cash of ₹137.7m and ₹2.29b worth of receivables due within a year. So it can boast ₹526.7m more liquid assets than total liabilities.

This surplus liquidity suggests that Tera Software's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. Having regard to this fact, we think its balance sheet is as strong as an ox.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

While Tera Software's debt to EBITDA ratio (4.4) suggests that it uses some debt, its interest cover is very weak, at 1.7, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, Tera Software's EBIT was down 52% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Tera Software 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Tera Software 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

Both Tera Software's EBIT growth rate and its conversion of EBIT to free cash flow were discouraging. But at least its level of total liabilities is a gleaming silver lining to those clouds. When we consider all the factors discussed, it seems to us that Tera Software is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Tera Software has 6 warning signs (and 3 which can't be ignored) we think 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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