The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Pegasystems Inc. (NASDAQ:PEGA) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is Pegasystems's Net Debt?

The chart below, which you can click on for greater detail, shows that Pegasystems had US$501.2m in debt in September 2024; about the same as the year before. But it also has US$703.0m in cash to offset that, meaning it has US$201.8m net cash.

How Healthy Is Pegasystems' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Pegasystems had liabilities of US$1.02b due within 12 months and liabilities of US$81.7m due beyond that. On the other hand, it had cash of US$703.0m and US$378.8m worth of receivables due within a year. So it has liabilities totalling US$24.5m more than its cash and near-term receivables, combined.

Having regard to Pegasystems' size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the US$8.15b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, Pegasystems also has more cash than debt, so we're pretty confident it can manage its debt safely.

Even more impressive was the fact that Pegasystems grew its EBIT by 5,423% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Pegasystems can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Pegasystems may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, Pegasystems actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Pegasystems has US$201.8m in net cash. And it impressed us with free cash flow of US$323m, being 268% of its EBIT. So we don't think Pegasystems's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Pegasystems you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.