Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, Baidu, Inc. (NASDAQ:BIDU) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.
What Is Baidu's Net Debt?
As you can see below, Baidu had CN¥68.2b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds CN¥145.3b in cash, so it actually has CN¥77.1b net cash.
How Strong Is Baidu's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Baidu had liabilities of CN¥61.6b due within 12 months and liabilities of CN¥69.4b due beyond that. Offsetting these obligations, it had cash of CN¥145.3b as well as receivables valued at CN¥8.35b due within 12 months. So it actually has CN¥22.6b more liquid assets than total liabilities.
This short term liquidity is a sign that Baidu could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Baidu boasts net cash, so it's fair to say it does not have a heavy debt load!
Better yet, Baidu grew its EBIT by 400% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Baidu 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. While Baidu has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Baidu actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While it is always sensible to investigate a company's debt, in this case Baidu has CN¥77.1b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥20b, being 122% of its EBIT. So is Baidu's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Baidu that you should be aware of before investing here.
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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