David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Alphabet Inc. (NASDAQ:GOOG.L) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 Alphabet's Debt?
As you can see below, at the end of March 2021, Alphabet had US$13.8b of debt, up from US$3.96b a year ago. Click the image for more detail. However, its balance sheet shows it holds US$135.1b in cash, so it actually has US$121.3b net cash.
How Healthy Is Alphabet's Balance Sheet?
We can see from the most recent balance sheet that Alphabet had liabilities of US$55.5b falling due within a year, and liabilities of US$41.6b due beyond that. Offsetting this, it had US$135.1b in cash and US$28.5b in receivables that were due within 12 months. So it actually has US$66.5b more liquid assets than total liabilities.
This surplus suggests that Alphabet has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Alphabet boasts net cash, so it's fair to say it does not have a heavy debt load!
In addition to that, we're happy to report that Alphabet has boosted its EBIT by 37%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Alphabet can strengthen its balance sheet over time. 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. Alphabet 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. During the last three years, Alphabet generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
While it is always sensible to investigate a company's debt, in this case Alphabet has US$121.3b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of US$51b, being 89% of its EBIT. So we don't think Alphabet's use of debt is risky. 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 instance, we've identified 1 warning sign for Alphabet that you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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