Does the software (ETR:SOW) use too many debts?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We can see that Aktiengesellschaft software (ETR:SOW) uses debt in its business. But the real question is whether this debt makes the business risky.

When is debt dangerous?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, many companies use debt to finance their growth, without any negative consequences. The first thing to do when considering how much debt a business has is to look at its cash and debt together.

See our latest analysis for software

How much debt does the software support?

As you can see below, at the end of June 2022, Software had a debt of 632.5 million euros, compared to 309.4 million euros a year ago. Click on the image for more details. However, he has €414.4 million in cash to offset this, resulting in a net debt of around €218.1 million.

How strong is the software’s balance sheet?

The latest balance sheet data shows that Software had liabilities of €497.4 million due within one year and liabilities of €637.3 million falling due thereafter. In return for these obligations, it had cash of €414.4 million as well as receivables worth €261.7 million at less than 12 months. Its liabilities therefore total €458.6 million more than the combination of its cash and short-term receivables.

While that might sound like a lot, it’s not too bad since Software has a market capitalization of 1.87 billion euros, so it could probably strengthen its balance sheet by raising capital if needed. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.

In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

Software’s net debt is only 1.5 times its EBITDA. And its EBIT covers its interest charges 35.8 times. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. But the bad news is that Software has seen its EBIT plunge 20% in the last twelve months. If this rate of decline in profits continues, the company could find itself in a difficult situation. There is no doubt that we learn the most about debt from the balance sheet. But future earnings, more than anything, will determine Software’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, while the taxman may love accounting profits, lenders only accept cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Software has produced strong free cash flow equivalent to 64% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.

Our point of view

Based on our analysis, Software’s interest coverage should signal that it won’t have too many problems with its debt. But the other factors we noted above weren’t so encouraging. To be precise, it seems about as good at (not) increasing your EBIT as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we feel a bit cautious about Software’s use of debt. While we understand that debt can improve return on equity, we suggest shareholders keep a close eye on their level of debt, lest it increase. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 1 software warning sign you should know.

Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.