Here's Why Softstar Entertainment (GTSM:6111) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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, Softstar Entertainment Inc. (GTSM:6111) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Softstar Entertainment

How Much Debt Does Softstar Entertainment Carry?

The image below, which you can click on for greater detail, shows that Softstar Entertainment had debt of NT$91.0m at the end of September 2020, a reduction from NT$171.0m over a year. However, its balance sheet shows it holds NT$166.8m in cash, so it actually has NT$75.9m net cash.

How Healthy Is Softstar Entertainment's Balance Sheet?

We can see from the most recent balance sheet that Softstar Entertainment had liabilities of NT$249.7m falling due within a year, and liabilities of NT$62.3m due beyond that. Offsetting these obligations, it had cash of NT$166.8m as well as receivables valued at NT$241.1m due within 12 months. So it actually has NT$95.9m more liquid assets than total liabilities.

This surplus suggests that Softstar Entertainment has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Softstar Entertainment boasts net cash, so it's fair to say it does not have a heavy debt load!

It was also good to see that despite losing money on the EBIT line last year, Softstar Entertainment turned things around in the last 12 months, delivering and EBIT of NT$115m. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Softstar Entertainment 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 company can only pay off debt with cold hard cash, not accounting profits. Softstar Entertainment may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last year, Softstar Entertainment created free cash flow amounting to 15% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Softstar Entertainment has net cash of NT$75.9m, as well as more liquid assets than liabilities. So we are not troubled with Softstar Entertainment's debt use. While Softstar Entertainment didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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