Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Microchip Technology Incorporated (NASDAQ:MCHP) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Microchip Technology's Net Debt?
As you can see below, Microchip Technology had US$10.1b of debt at June 2019, down from US$11.3b a year prior. However, it also had US$437.1m in cash, and so its net debt is US$9.65b.
A Look At Microchip Technology's Liabilities
According to the last reported balance sheet, Microchip Technology had liabilities of US$2.45b due within 12 months, and liabilities of US$10.5b due beyond 12 months. On the other hand, it had cash of US$437.1m and US$936.8m worth of receivables due within a year. So its liabilities total US$11.6b more than the combination of its cash and short-term receivables.
Microchip Technology has a very large market capitalization of US$22.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Microchip Technology's debt to EBITDA ratio (4.7) suggests that it uses some debt, its interest cover is very weak, at 1.9, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that Microchip Technology improved its EBIT by 4.0% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Microchip Technology'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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Microchip Technology 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.
When it comes to the balance sheet, the standout positive for Microchip Technology was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. In particular, interest cover gives us cold feet. Looking at all this data makes us feel a little cautious about Microchip Technology's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Microchip Technology insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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