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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 can see that Materion Corporation (NYSE:MTRN) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Materion's Debt?
The image below, which you can click on for greater detail, shows that Materion had debt of US$2.52m at the end of June 2019, a reduction from US$19.1m over a year. But it also has US$74.9m in cash to offset that, meaning it has US$72.3m net cash.
How Healthy Is Materion's Balance Sheet?
We can see from the most recent balance sheet that Materion had liabilities of US$125.0m falling due within a year, and liabilities of US$117.0m due beyond that. On the other hand, it had cash of US$74.9m and US$142.3m worth of receivables due within a year. So its liabilities total US$24.9m more than the combination of its cash and short-term receivables.
Given Materion has a market capitalization of US$1.20b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Materion boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact Materion's saving grace is its low debt levels, because its EBIT has tanked 33% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Materion 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Materion 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, Materion actually produced more free cash flow than EBIT over the last three years. 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 Materion has US$72.3m in net cash. The cherry on top was that in converted 108% of that EBIT to free cash flow, bringing in US$48m. So we don't have any problem with Materion's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Materion insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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