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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Semiconductor Manufacturing International Corporation (HKG:981) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Semiconductor Manufacturing International's Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2021 Semiconductor Manufacturing International had US$5.58b of debt, an increase on US$4.75b, over one year. However, its balance sheet shows it holds US$11.8b in cash, so it actually has US$6.17b net cash.
How Strong Is Semiconductor Manufacturing International's Balance Sheet?
We can see from the most recent balance sheet that Semiconductor Manufacturing International had liabilities of US$2.92b falling due within a year, and liabilities of US$5.70b due beyond that. Offsetting these obligations, it had cash of US$11.8b as well as receivables valued at US$886.5m due within 12 months. So it actually has US$4.02b more liquid assets than total liabilities.
This surplus suggests that Semiconductor Manufacturing International is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Semiconductor Manufacturing International 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, Semiconductor Manufacturing International turned things around in the last 12 months, delivering and EBIT of US$26m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Semiconductor Manufacturing 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 company can only pay off debt with cold hard cash, not accounting profits. Semiconductor Manufacturing International may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, Semiconductor Manufacturing International saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
While it is always sensible to investigate a company's debt, in this case Semiconductor Manufacturing International has US$6.17b in net cash and a decent-looking balance sheet. So we are not troubled with Semiconductor Manufacturing International's debt use. 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 3 warning signs with Semiconductor Manufacturing International (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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