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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Motorola Solutions, Inc. (NYSE:MSI) does use debt in its business. But should shareholders be worried about its use of debt?
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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Motorola Solutions's Debt?
The image below, which you can click on for greater detail, shows that Motorola Solutions had debt of US$5.31b at the end of June 2019, a reduction from US$5.65b over a year. However, because it has a cash reserve of US$953.0m, its net debt is less, at about US$4.35b.
How Healthy Is Motorola Solutions's Balance Sheet?
The latest balance sheet data shows that Motorola Solutions had liabilities of US$2.88b due within a year, and liabilities of US$8.05b falling due after that. Offsetting these obligations, it had cash of US$953.0m as well as receivables valued at US$2.12b due within 12 months. So its liabilities total US$7.86b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Motorola Solutions has a huge market capitalization of US$30.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a debt to EBITDA ratio of 2.2, Motorola Solutions uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.1 times its interest expenses harmonizes with that theme. One way Motorola Solutions could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 14%, as it did over the last year. 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 Motorola Solutions 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Motorola Solutions produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Motorola Solutions's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And we also thought its EBIT growth rate was a positive. Looking at all the aforementioned factors together, it strikes us that Motorola Solutions can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. We'd be motivated to research the stock further if we found out that Motorola Solutions insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
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