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.' 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 Electronic Arts Inc. (NASDAQ:EA) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Electronic Arts's Net Debt?
The chart below, which you can click on for greater detail, shows that Electronic Arts had US$997.0m in debt in December 2020; about the same as the year before. But on the other hand it also has US$6.71b in cash, leading to a US$5.71b net cash position.
A Look At Electronic Arts' Liabilities
The latest balance sheet data shows that Electronic Arts had liabilities of US$3.49b due within a year, and liabilities of US$965.0m falling due after that. Offsetting this, it had US$6.71b in cash and US$778.0m in receivables that were due within 12 months. So it actually has US$3.03b more liquid assets than total liabilities.
This surplus suggests that Electronic Arts has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Electronic Arts boasts net cash, so it's fair to say it does not have a heavy debt load!
While Electronic Arts doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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 Electronic Arts's ability to maintain a healthy balance sheet going forward. 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. While Electronic Arts 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, Electronic Arts 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 we empathize with investors who find debt concerning, you should keep in mind that Electronic Arts has net cash of US$5.71b, as well as more liquid assets than liabilities. The cherry on top was that in converted 126% of that EBIT to free cash flow, bringing in US$1.9b. So we don't think Electronic Arts's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Electronic Arts you should be aware of.
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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