Warren Buffett famously said, '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. We can see that International Business Machines Corporation (NYSE:IBM) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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.
How Much Debt Does International Business Machines Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 International Business Machines had US$73.0b of debt, an increase on US$45.6b, over one year. However, it does have US$46.3b in cash offsetting this, leading to net debt of about US$26.8b.
A Look At International Business Machines's Liabilities
Zooming in on the latest balance sheet data, we can see that International Business Machines had liabilities of US$42.4b due within 12 months and liabilities of US$94.5b due beyond that. Offsetting this, it had US$46.3b in cash and US$9.20b in receivables that were due within 12 months. So it has liabilities totalling US$81.4b more than its cash and near-term receivables, combined.
This is a mountain of leverage even relative to its gargantuan market capitalization of US$132.8b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
We'd say that International Business Machines's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its strong interest cover of 17.2 times, makes us even more comfortable. Sadly, International Business Machines's EBIT actually dropped 6.4% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 International Business Machines can strengthen its balance sheet over time. 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, International Business Machines generated free cash flow amounting to a very robust 98% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Both International Business Machines's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think International Business Machines is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that International Business Machines insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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