Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. We can see that NetScout Systems, Inc. (NASDAQ:NTCT) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
What Is NetScout Systems’s Debt?
As you can see below, NetScout Systems had US$500.0m of debt at June 2019, down from US$600.0m a year prior. On the flip side, it has US$438.1m in cash leading to net debt of about US$61.9m.
How Strong Is NetScout Systems’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that NetScout Systems had liabilities of US$349.6m due within 12 months and liabilities of US$833.0m due beyond that. Offsetting these obligations, it had cash of US$438.1m as well as receivables valued at US$160.0m due within 12 months. So its liabilities total US$584.5m more than the combination of its cash and short-term receivables.
NetScout Systems has a market capitalization of US$1.65b, 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.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Given net debt is only 0.46 times EBITDA, it is initially surprising to see that NetScout Systems’s EBIT has low interest coverage of 0.40 times. So while we’re not necessarily alarmed we think that its debt is far from trivial. We also note that NetScout Systems improved its EBIT from a last year’s loss to a positive US$8.3m. 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 NetScout Systems 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, NetScout Systems actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
NetScout Systems’s interest cover was a real negative on this analysis, although the other factors we considered were considerably better There’s no doubt that its ability to convert EBIT to free cash flow is pretty flash. When we consider all the elements mentioned above, it seems to us that NetScout Systems is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that NetScout Systems 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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