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. 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 note that NetApp, Inc. (NASDAQ:NTAP) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is NetApp's Debt?
You can click the graphic below for the historical numbers, but it shows that NetApp had US$1.58b of debt in July 2019, down from US$1.74b, one year before. However, its balance sheet shows it holds US$3.54b in cash, so it actually has US$1.97b net cash.
How Strong Is NetApp's Balance Sheet?
The latest balance sheet data shows that NetApp had liabilities of US$3.18b due within a year, and liabilities of US$3.77b falling due after that. Offsetting these obligations, it had cash of US$3.54b as well as receivables valued at US$542.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.87b.
NetApp has a very large market capitalization of US$12.4b, 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. While it does have liabilities worth noting, NetApp also has more cash than debt, so we're pretty confident it can manage its debt safely.
But the other side of the story is that NetApp saw its EBIT decline by 3.4% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine NetApp'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. NetApp 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, NetApp actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although NetApp's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$1.97b. And it impressed us with free cash flow of US$1.2b, being 119% of its EBIT. So we are not troubled with NetApp's debt use. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that NetApp insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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