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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Cadence Design Systems, Inc. (NASDAQ:CDNS) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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?
The image below, which you can click on for greater detail, shows that at September 2020 Cadence Design Systems had debt of US$586.2m, up from US$345.8m in one year. But it also has US$1.31b in cash to offset that, meaning it has US$720.3m net cash.
A Look At Cadence Design Systems' Liabilities
We can see from the most recent balance sheet that Cadence Design Systems had liabilities of US$1.12b falling due within a year, and liabilities of US$626.5m due beyond that. Offsetting these obligations, it had cash of US$1.31b as well as receivables valued at US$309.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$128.8m.
This state of affairs indicates that Cadence Design Systems' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the US$39.0b company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, Cadence Design Systems also has more cash than debt, so we're pretty confident it can manage its debt safely.
Also good is that Cadence Design Systems grew its EBIT at 14% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 company can only pay off debt with cold hard cash, not accounting profits. Cadence Design Systems 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 last three years, Cadence Design Systems actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Cadence Design Systems has US$720.3m in net cash. The cherry on top was that in converted 137% of that EBIT to free cash flow, bringing in US$838m. So we don't think Cadence Design Systems's use of debt is risky. We'd be very excited to see if Cadence Design Systems insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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