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 can see that Electronic Arts Inc. (NASDAQ:EA) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Electronic Arts's Debt?
The chart below, which you can click on for greater detail, shows that Electronic Arts had US$995.0m in debt in December 2019; about the same as the year before. However, its balance sheet shows it holds US$5.60b in cash, so it actually has US$4.61b net cash.
How Strong Is Electronic Arts's Balance Sheet?
We can see from the most recent balance sheet that Electronic Arts had liabilities of US$2.34b falling due within a year, and liabilities of US$1.59b due beyond that. Offsetting this, it had US$5.60b in cash and US$798.0m in receivables that were due within 12 months. So it can boast US$2.48b more liquid assets than total liabilities.
This surplus suggests that Electronic Arts has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Electronic Arts boasts net cash, so it's fair to say it does not have a heavy debt load!
But the bad news is that Electronic Arts has seen its EBIT plunge 19% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Electronic Arts'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Electronic Arts 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, Electronic Arts actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While we empathize with investors who find debt concerning, you should keep in mind that Electronic Arts has net cash of US$4.61b, as well as more liquid assets than liabilities. The cherry on top was that in converted 109% of that EBIT to free cash flow, bringing in US$1.8b. So we are not troubled with Electronic Arts's debt use. 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. For instance, we've identified 2 warning signs for Electronic Arts that you should be aware of.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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