Magic Software Enterprises (NASDAQ:MGIC) Could Easily Take On More Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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, Magic Software Enterprises Ltd. (NASDAQ:MGIC) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Magic Software Enterprises

How Much Debt Does Magic Software Enterprises Carry?

As you can see below, at the end of June 2022, Magic Software Enterprises had US$56.5m of debt, up from US$37.2m a year ago. Click the image for more detail. However, it does have US$92.3m in cash offsetting this, leading to net cash of US$35.8m.

A Look At Magic Software Enterprises' Liabilities

According to the last reported balance sheet, Magic Software Enterprises had liabilities of US$106.7m due within 12 months, and liabilities of US$91.9m due beyond 12 months. Offsetting this, it had US$92.3m in cash and US$154.5m in receivables that were due within 12 months. So it actually has US$48.2m more liquid assets than total liabilities.

This surplus suggests that Magic Software Enterprises has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Magic Software Enterprises has more cash than debt is arguably a good indication that it can manage its debt safely.

Also positive, Magic Software Enterprises grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Magic Software Enterprises can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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 most recent three years, Magic Software Enterprises recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case Magic Software Enterprises has US$35.8m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 75% of that EBIT to free cash flow, bringing in US$19m. So is Magic Software Enterprises'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. Case in point: We've spotted 1 warning sign for Magic Software Enterprises you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.