The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Microsoft Corporation (NASDAQ:MSFT) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Microsoft's Debt?
The image below, which you can click on for greater detail, shows that Microsoft had debt of US$78.8b at the end of June 2019, a reduction from US$87.5b over a year. However, it does have US$133.8b in cash offsetting this, leading to net cash of US$55.1b.
A Look At Microsoft's Liabilities
We can see from the most recent balance sheet that Microsoft had liabilities of US$69.4b falling due within a year, and liabilities of US$114.8b due beyond that. Offsetting these obligations, it had cash of US$133.8b as well as receivables valued at US$29.5b due within 12 months. So it has liabilities totalling US$20.9b more than its cash and near-term receivables, combined.
This state of affairs indicates that Microsoft's 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$1.05t company is struggling for cash, we still think it's worth monitoring its balance sheet. Despite its noteworthy liabilities, Microsoft boasts net cash, so it's fair to say it does not have a heavy debt load!
Another good sign is that Microsoft has been able to increase its EBIT by 23% in twelve months, making it easier to pay down debt. 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 Microsoft's ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Microsoft has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Microsoft generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Microsoft has US$55b in net cash. The cherry on top was that in converted 95% of that EBIT to free cash flow, bringing in US$38b. So is Microsoft's debt a risk? It doesn't seem so to us. Another factor that would give us confidence in Microsoft would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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