Tera Software (NSE: TERASOFT) takes certain risks with its use of debt

Howard Marks put it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried. It’s only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We notice that Tera Software Limited (NSE: TERASOFT) has debt on its balance sheet. But the most important question is: what risk does this debt create?

What risk does debt entail?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we look at debt levels, we first look at cash and debt levels, together.

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What is Tera Software’s debt?

As you can see below, at the end of September 2021, Tera Software had a debt of 640.9 million yen, up from 499.7 million yen a year ago. Click on the image for more details. However, because he has a cash reserve of 109.5 million yen, his net debt is less, at around 531.3 million yen.

History of debt versus equity of NSEI: TERASOFT December 11, 2021

How healthy is Tera Software’s balance sheet?

Zooming in on the latest balance sheet data, we can see that Tera Software had a liability of 1.86 billion yen owed within 12 months and a liability of 56.7 million yen owed beyond that. On the other hand, he had a cash position of 109.5 million yen and a value of 1.97 billion yen in debts due within a year. So he’s actually 170.8m Following liquid assets as total liabilities.

This excess liquidity suggests that Tera Software is taking a cautious approach to debt. Given that he has easily sufficient short-term liquidity, we don’t think he will have any problems with his lenders.

We measure a company’s indebtedness relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) covers its interests. costs (interest coverage). Thus, we look at debt versus earnings with and without amortization expenses.

Tera Software shareholders face the double whammy of a high net debt / EBITDA ratio (5.1) and relatively low interest coverage, since EBIT is only 1.5 times expenses of interest. This means that we would consider him to be in heavy debt. Another investor concern could be that Tera Software’s EBIT fell 14% last year. If things continue like this, managing the debt will be about as easy as putting an angry house cat in its travel box. When analyzing debt levels, the balance sheet is the obvious place to start. But it is the profits of Tera Software that will influence the balance sheet in the future. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.

Finally, a business can only repay its debts with hard cash, not with accounting profits. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Tera Software has experienced substantial total negative free cash flow. While this may be the result of spending for growth, it makes debt much riskier.

Our point of view

To be frank, Tera Software’s interest coverage and track record of converting EBIT to free cash flow makes us rather uncomfortable with its debt levels. But at least he’s pretty decent to stay on top of his total liabilities; it’s encouraging. Once we consider all of the above factors together it seems like Tera Software’s debt makes it a bit risky. Some people like this kind of risk, but we are aware of the potential pitfalls, so we would probably prefer him to carry less debt. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. Concrete example: we have spotted 5 warning signs for Tera software you need to be aware, and 4 of them are important.

At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.