Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Persistent Systems Limited (NSE:PERSISTENT) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Persistent Systems's Debt?
You can click the graphic below for the historical numbers, but it shows that Persistent Systems had ₹16.6m of debt in June 2019, down from ₹21.1m, one year before. But it also has ₹9.13b in cash to offset that, meaning it has ₹9.11b net cash.
How Strong Is Persistent Systems's Balance Sheet?
We can see from the most recent balance sheet that Persistent Systems had liabilities of ₹4.44b falling due within a year, and liabilities of ₹765.4m due beyond that. Offsetting this, it had ₹9.13b in cash and ₹6.82b in receivables that were due within 12 months. So it actually has ₹10.8b more liquid assets than total liabilities.
It's good to see that Persistent Systems has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Persistent Systems has more cash than debt is arguably a good indication that it can manage its debt safely.
Also good is that Persistent Systems grew its EBIT at 16% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Persistent Systems'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Persistent Systems has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Persistent Systems recorded free cash flow worth a fulsome 87% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Persistent Systems has net cash of ₹9.1b, as well as more liquid assets than liabilities. The cherry on top was that in converted 87% of that EBIT to free cash flow, bringing in ₹3.6b. So we don't think Persistent Systems's use of debt is risky. We'd be very excited to see if Persistent Systems insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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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