These 4 Measures Indicate That Open Text (NASDAQ:OTEX) Is Using Debt Reasonably Well

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 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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Open Text

What Is Open Text's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Open Text had US$6.39b of debt in June 2024, down from US$8.88b, one year before. However, because it has a cash reserve of US$1.28b, its net debt is less, at about US$5.11b.

A Look At Open Text's Liabilities

According to the last reported balance sheet, Open Text had liabilities of US$2.80b due within 12 months, and liabilities of US$7.21b due beyond 12 months. Offsetting this, it had US$1.28b in cash and US$753.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.97b.

This is a mountain of leverage relative to its market capitalization of US$8.91b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

While we wouldn't worry about Open Text's net debt to EBITDA ratio of 3.2, we think its super-low interest cover of 2.1 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that Open Text grew its EBIT a smooth 49% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Open Text generated free cash flow amounting to a very robust 99% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Open Text's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. But truth be told its interest cover had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that Open Text is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Open Text (of which 1 is a bit unpleasant!) you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.