David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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, Avid Technology, Inc. (NASDAQ:AVID) does carry debt. But the more important question is: how much risk is that debt creating?
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. 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.
How Much Debt Does Avid Technology Carry?
The chart below, which you can click on for greater detail, shows that Avid Technology had US$229.1m in debt in June 2019; about the same as the year before. However, because it has a cash reserve of US$51.0m, its net debt is less, at about US$178.1m.
How Strong Is Avid Technology's Balance Sheet?
We can see from the most recent balance sheet that Avid Technology had liabilities of US$206.9m falling due within a year, and liabilities of US$251.0m due beyond that. On the other hand, it had cash of US$51.0m and US$77.1m worth of receivables due within a year. So its liabilities total US$329.9m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of US$271.1m, we think shareholders really should watch Avid Technology's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Avid Technology's debt to EBITDA ratio (4.6) suggests that it uses some debt, its interest cover is very weak, at 1.3, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The silver lining is that Avid Technology grew its EBIT by 1489% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. 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 Avid Technology 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Avid Technology actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Mulling over Avid Technology's attempt at covering its interest expense with its EBIT, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Avid Technology's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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