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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies NetApp, Inc. (NASDAQ:NTAP) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does NetApp Carry?
You can click the graphic below for the historical numbers, but it shows that as of July 2020 NetApp had US$2.78b of debt, an increase on US$1.58b, over one year. However, its balance sheet shows it holds US$3.78b in cash, so it actually has US$1.00b net cash.
How Strong Is NetApp's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that NetApp had liabilities of US$2.98b due within 12 months and liabilities of US$5.16b due beyond that. Offsetting these obligations, it had cash of US$3.78b as well as receivables valued at US$604.0m due within 12 months. So it has liabilities totalling US$3.75b more than its cash and near-term receivables, combined.
This deficit isn't so bad because NetApp is worth US$9.19b, and thus could probably raise enough capital to shore up 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. Despite its noteworthy liabilities, NetApp boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, NetApp saw its EBIT drop by 7.6% in the last twelve months. 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 company can only pay off debt with cold hard cash, not accounting profits. 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. Happily for any shareholders, NetApp actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
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$1.00b. And it impressed us with free cash flow of US$846m, being 111% of its EBIT. So we don't have any problem with NetApp's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with NetApp .
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.
This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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