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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Magic Software Enterprises Ltd. (NASDAQ:MGIC) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Magic Software Enterprises's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Magic Software Enterprises had US$65.8m of debt in September 2024, down from US$87.9m, one year before. However, its balance sheet shows it holds US$99.7m in cash, so it actually has US$33.9m net cash.

How Strong Is Magic Software Enterprises' Balance Sheet?

According to the last reported balance sheet, Magic Software Enterprises had liabilities of US$149.1m due within 12 months, and liabilities of US$72.6m due beyond 12 months. Offsetting this, it had US$99.7m in cash and US$162.2m in receivables that were due within 12 months. So it actually has US$40.2m more liquid assets than total liabilities.

This short term liquidity is a sign that Magic Software Enterprises could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Magic Software Enterprises has more cash than debt is arguably a good indication that it can manage its debt safely.

While Magic Software Enterprises doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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 Magic Software Enterprises'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. While Magic Software Enterprises 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. During the last three years, Magic Software Enterprises generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Magic Software Enterprises has US$33.9m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of US$48m, being 89% of its EBIT. So we don't think Magic Software Enterprises's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Magic Software Enterprises that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.