Is Open Text (NASDAQ:OTEX) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Open Text Corporation (NASDAQ:OTEX) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Open Text

What Is Open Text's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Open Text had US$4.19b of debt, an increase on US$2.61b, over one year. On the flip side, it has US$1.85b in cash leading to net debt of about US$2.35b.

How Strong Is Open Text's Balance Sheet?

The latest balance sheet data shows that Open Text had liabilities of US$1.78b due within a year, and liabilities of US$4.31b falling due after that. Offsetting these obligations, it had cash of US$1.85b as well as receivables valued at US$450.0m due within 12 months. So its liabilities total US$3.80b more than the combination of its cash and short-term receivables.

Open Text has a very large market capitalization of US$12.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Open Text's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 4.6 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We saw Open Text grow its EBIT by 7.2% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Open Text'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Open Text actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Open Text's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But truth be told we feel its interest cover does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Open Text can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Open Text that you should be aware of.

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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