Does Micro Focus International (LON:MCRO) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Micro Focus International plc (LON:MCRO) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Micro Focus International

What Is Micro Focus International's Debt?

As you can see below, Micro Focus International had US$4.65b of debt at April 2021, down from US$4.95b a year prior. However, because it has a cash reserve of US$698.1m, its net debt is less, at about US$3.96b.

How Healthy Is Micro Focus International's Balance Sheet?

The latest balance sheet data shows that Micro Focus International had liabilities of US$1.76b due within a year, and liabilities of US$5.91b falling due after that. Offsetting this, it had US$698.1m in cash and US$684.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$6.29b.

This deficit casts a shadow over the US$1.68b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Micro Focus International would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Weak interest cover of 0.74 times and a disturbingly high net debt to EBITDA ratio of 6.3 hit our confidence in Micro Focus International like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Micro Focus International's EBIT was down 58% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Micro Focus International'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Micro Focus International actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both Micro Focus International's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. After considering the datapoints discussed, we think Micro Focus International has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Micro Focus International , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.

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