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. 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. As with many other companies Splunk Inc. (NASDAQ:SPLK) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Splunk’s Debt?
The image below, which you can click on for greater detail, shows that at October 2019 Splunk had debt of US$1.69b, up from US$1.6k in one year. But it also has US$1.82b in cash to offset that, meaning it has US$127.9m net cash.
A Look At Splunk’s Liabilities
We can see from the most recent balance sheet that Splunk had liabilities of US$1.14b falling due within a year, and liabilities of US$2.11b due beyond that. Offsetting this, it had US$1.82b in cash and US$638.1m in receivables that were due within 12 months. So its liabilities total US$783.8m more than the combination of its cash and short-term receivables.
Of course, Splunk has a titanic market capitalization of US$24.3b, so these liabilities are probably manageable. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Splunk also has more cash than debt, so we’re pretty confident it can manage its debt safely. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 3 warning signs for Splunk which any shareholder or potential investor should be aware of.
In the last year Splunk wasn’t profitable at an EBIT level, but managed to grow its revenue by 33%, to US$2.2b. Shareholders probably have their fingers crossed that it can grow its way to profits.
So How Risky Is Splunk?
We have no doubt that loss making companies are, in general, riskier than profitable ones. And we do note that Splunk had negative earnings before interest and tax (EBIT), over the last year. Indeed, in that time it burnt through US$163m of cash and made a loss of US$312m. While this does make the company a bit risky, it’s important to remember it has net cash of US$127.9m. That kitty means the company can keep spending for growth for at least two years, at current rates. Splunk’s revenue growth shone bright over the last year, so it may well be in a position to turn a profit in due course. Pre-profit companies are often risky, but they can also offer great rewards. When I consider a company to be a bit risky, I think it is responsible to check out whether insiders have been reporting any share sales. Luckily, you can click here ito see our graphic depicting Splunk insider transactions.
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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