Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that Alarm.com Holdings, Inc. (NASDAQ:ALRM) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
How Much Debt Does Alarm.com Holdings Carry?
As you can see below, at the end of June 2020, Alarm.com Holdings had US$112.0m of debt, up from US$65.0m a year ago. Click the image for more detail. But on the other hand it also has US$205.8m in cash, leading to a US$93.8m net cash position.
How Healthy Is Alarm.com Holdings's Balance Sheet?
We can see from the most recent balance sheet that Alarm.com Holdings had liabilities of US$92.8m falling due within a year, and liabilities of US$165.9m due beyond that. On the other hand, it had cash of US$205.8m and US$76.7m worth of receivables due within a year. So it can boast US$23.8m more liquid assets than total liabilities.
Having regard to Alarm.com Holdings's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$2.80b company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, Alarm.com Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
And we also note warmly that Alarm.com Holdings grew its EBIT by 16% last year, making its debt load easier to handle. 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 Alarm.com Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Alarm.com Holdings 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. Over the most recent three years, Alarm.com Holdings recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to investigate a company's debt, in this case Alarm.com Holdings has US$93.8m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of US$47m, being 78% of its EBIT. So we don't think Alarm.com Holdings's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Alarm.com Holdings you should be aware of, and 1 of them is a bit concerning.
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.
This article by Simply Wall St is general in nature. 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.
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