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.' 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. As with many other companies Cadence Design Systems, Inc. (NASDAQ:CDNS) makes use of debt. But the more important question is: how much risk is that debt creating?
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. If things get really bad, the lenders can take control of the business. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Cadence Design Systems's Debt?
As you can see below, Cadence Design Systems had US$347.8m of debt, at April 2022, which is about the same as the year before. You can click the chart for greater detail. But it also has US$1.13b in cash to offset that, meaning it has US$787.0m net cash.
How Strong Is Cadence Design Systems' Balance Sheet?
According to the last reported balance sheet, Cadence Design Systems had liabilities of US$960.8m due within 12 months, and liabilities of US$674.1m due beyond 12 months. On the other hand, it had cash of US$1.13b and US$380.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$119.3m.
Having regard to Cadence Design Systems' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$38.9b company is struggling for cash, we still think it's worth monitoring its balance sheet. Despite its noteworthy liabilities, Cadence Design Systems boasts net cash, so it's fair to say it does not have a heavy debt load!
Another good sign is that Cadence Design Systems has been able to increase its EBIT by 24% in twelve months, making it easier to pay down debt. 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 Cadence Design Systems'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. While Cadence Design 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, Cadence Design Systems actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
We could understand if investors are concerned about Cadence Design Systems's liabilities, but we can be reassured by the fact it has has net cash of US$787.0m. The cherry on top was that in converted 125% of that EBIT to free cash flow, bringing in US$1.2b. So is Cadence Design Systems's debt a risk? It doesn't seem so to us. 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. For example - Cadence Design Systems has 1 warning sign we think you should be aware of.
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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