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 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. Importantly, Palo Alto Networks, Inc. (NASDAQ:PANW) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 Palo Alto Networks's Debt?
You can click the graphic below for the historical numbers, but it shows that Palo Alto Networks had US$1.99b of debt in July 2023, down from US$3.68b, one year before. But on the other hand it also has US$2.39b in cash, leading to a US$398.5m net cash position.
A Look At Palo Alto Networks' Liabilities
According to the last reported balance sheet, Palo Alto Networks had liabilities of US$7.74b due within 12 months, and liabilities of US$5.02b due beyond 12 months. On the other hand, it had cash of US$2.39b and US$2.85b worth of receivables due within a year. So its liabilities total US$7.51b more than the combination of its cash and short-term receivables.
Since publicly traded Palo Alto Networks shares are worth a very impressive total of US$72.6b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Palo Alto Networks boasts net cash, so it's fair to say it does not have a heavy debt load!
It was also good to see that despite losing money on the EBIT line last year, Palo Alto Networks turned things around in the last 12 months, delivering and EBIT of US$387m. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Palo Alto Networks can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Palo Alto Networks 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. Over the last year, Palo Alto Networks actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While Palo Alto Networks does have more liabilities than liquid assets, it also has net cash of US$398.5m. And it impressed us with free cash flow of US$2.6b, being 679% of its EBIT. So we don't think Palo Alto Networks's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Palo Alto Networks you should be aware of.
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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.