Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Fabrinet (NYSE:FN) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Fabrinet Carry?
The image below, which you can click on for greater detail, shows that Fabrinet had debt of US$60.0m at the end of March 2020, a reduction from US$63.4m over a year. However, it does have US$457.8m in cash offsetting this, leading to net cash of US$397.7m.
How Strong Is Fabrinet's Balance Sheet?
According to the last reported balance sheet, Fabrinet had liabilities of US$327.5m due within 12 months, and liabilities of US$69.4m due beyond 12 months. Offsetting this, it had US$457.8m in cash and US$324.2m in receivables that were due within 12 months. So it actually has US$385.1m more liquid assets than total liabilities.
This surplus suggests that Fabrinet is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, Fabrinet boasts net cash, so it's fair to say it does not have a heavy debt load!
The good news is that Fabrinet has increased its EBIT by 7.5% over twelve months, which should ease any concerns about debt repayment. 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 Fabrinet can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Fabrinet 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, Fabrinet recorded free cash flow worth a fulsome 90% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
While it is always sensible to investigate a company's debt, in this case Fabrinet has US$397.7m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of US$113m, being 90% of its EBIT. So we don't think Fabrinet's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Fabrinet 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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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. Thank you for reading.