Is Magic Software Enterprises (NASDAQ:MGIC) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Magic Software Enterprises Ltd. (NASDAQ:MGIC) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Magic Software Enterprises

How Much Debt Does Magic Software Enterprises Carry?

You can click the graphic below for the historical numbers, but it shows that Magic Software Enterprises had US$22.6m of debt in December 2019, down from US$28.0m, one year before. But on the other hand it also has US$95.5m in cash, leading to a US$72.9m net cash position.

How Healthy Is Magic Software Enterprises's Balance Sheet?

The latest balance sheet data shows that Magic Software Enterprises had liabilities of US$66.9m due within a year, and liabilities of US$54.0m falling due after that. On the other hand, it had cash of US$95.5m and US$109.5m worth of receivables due within a year. So it can boast US$84.2m more liquid assets than total liabilities.

This surplus suggests that Magic Software Enterprises is using debt in a way that is appears to be both safe and conservative. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Succinctly put, Magic Software Enterprises boasts net cash, so it's fair to say it does not have a heavy debt load!

The good news is that Magic Software Enterprises has increased its EBIT by 6.8% over twelve months, which should ease any concerns about debt repayment. 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 Magic Software Enterprises's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Magic Software Enterprises 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. Over the last three years, Magic Software Enterprises recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing up

While it is always sensible to investigate a company's debt, in this case Magic Software Enterprises has US$72.9m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 89% of that EBIT to free cash flow, bringing in US$40m. So we don't think Magic Software Enterprises's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we've spotted 4 warning signs for Magic Software Enterprises you should know about.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

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