Stock Analysis

Is Illumina (NASDAQ:ILMN) Using Too Much Debt?

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NasdaqGS:ILMN
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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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Illumina, Inc. (NASDAQ:ILMN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

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What Is Illumina's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of January 2022 Illumina had US$1.70b of debt, an increase on US$1.18b, over one year. However, it does have US$1.34b in cash offsetting this, leading to net debt of about US$356.0m.

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NasdaqGS:ILMN Debt to Equity History March 5th 2022

How Healthy Is Illumina's Balance Sheet?

The latest balance sheet data shows that Illumina had liabilities of US$1.09b due within a year, and liabilities of US$3.38b falling due after that. Offsetting these obligations, it had cash of US$1.34b as well as receivables valued at US$664.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.47b.

Given Illumina has a humongous market capitalization of US$50.8b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Illumina has a very light debt load indeed.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Illumina has a low net debt to EBITDA ratio of only 0.39. And its EBIT easily covers its interest expense, being 10.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Illumina saw its EBIT decline by 3.2% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Illumina 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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Illumina recorded free cash flow worth a fulsome 90% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that Illumina's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its EBIT growth rate. Zooming out, Illumina seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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 3 warning signs for Illumina you should be aware of.

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.

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