Tera Software (NSE:TERASOFT) Takes On Some Risk With Its Use Of Debt

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.' 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. We note that Tera Software Limited (NSE:TERASOFT) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Tera Software

What Is Tera Software's Debt?

As you can see below, at the end of September 2021, Tera Software had ₹640.9m of debt, up from ₹499.7m a year ago. Click the image for more detail. However, because it has a cash reserve of ₹109.5m, its net debt is less, at about ₹531.3m.

How Healthy Is Tera Software's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tera Software had liabilities of ₹1.86b due within 12 months and liabilities of ₹56.7m due beyond that. On the other hand, it had cash of ₹109.5m and ₹1.97b worth of receivables due within a year. So it actually has ₹170.8m more liquid assets than total liabilities.

This excess liquidity suggests that Tera Software is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders.

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

Tera Software shareholders face the double whammy of a high net debt to EBITDA ratio (5.1), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. This means we'd consider it to have a heavy debt load. Another concern for investors might be that Tera Software's EBIT fell 14% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But it is Tera Software's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Tera Software saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Tera Software's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Once we consider all the factors above, together, it seems to us that Tera Software's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Case in point: We've spotted 5 warning signs for Tera Software you should be aware of, and 4 of them are significant.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.