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 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 can see that Analog Devices, Inc. (NASDAQ:ADI) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Analog Devices
How Much Debt Does Analog Devices Carry?
As you can see below, at the end of January 2023, Analog Devices had US$6.54b of debt, up from US$6.25b a year ago. Click the image for more detail. However, because it has a cash reserve of US$1.67b, its net debt is less, at about US$4.87b.
How Healthy Is Analog Devices' Balance Sheet?
We can see from the most recent balance sheet that Analog Devices had liabilities of US$2.43b falling due within a year, and liabilities of US$11.3b due beyond that. On the other hand, it had cash of US$1.67b and US$1.63b worth of receivables due within a year. So its liabilities total US$10.4b more than the combination of its cash and short-term receivables.
Of course, Analog Devices has a titanic market capitalization of US$99.3b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Analog Devices's net debt is only 0.71 times its EBITDA. And its EBIT easily covers its interest expense, being 23.7 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Analog Devices grew its EBIT by 93% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Analog Devices'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. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Analog Devices actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Our View
The good news is that Analog Devices's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. We think Analog Devices is no more beholden to its lenders, than the birds are to birdwatchers. To our minds it has a healthy happy balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Analog Devices that you should be aware of.
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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
About NasdaqGS:ADI
Analog Devices
Engages in the design, manufacture, testing, and marketing of integrated circuits (ICs), software, and subsystems products in the United States, rest of North and South America, Europe, Japan, China, and rest of Asia.
Excellent balance sheet with reasonable growth potential and pays a dividend.
