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 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. As with many other companies FormFactor, Inc. (NASDAQ:FORM) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does FormFactor Carry?
The image below, which you can click on for greater detail, shows that FormFactor had debt of US$29.5m at the end of June 2021, a reduction from US$50.1m over a year. However, its balance sheet shows it holds US$256.2m in cash, so it actually has US$226.8m net cash.
How Strong Is FormFactor's Balance Sheet?
The latest balance sheet data shows that FormFactor had liabilities of US$153.9m due within a year, and liabilities of US$65.1m falling due after that. Offsetting this, it had US$256.2m in cash and US$111.9m in receivables that were due within 12 months. So it actually has US$149.1m more liquid assets than total liabilities.
This short term liquidity is a sign that FormFactor could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, FormFactor boasts net cash, so it's fair to say it does not have a heavy debt load!
Also positive, FormFactor grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if FormFactor 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While FormFactor 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. Happily for any shareholders, FormFactor 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.
While we empathize with investors who find debt concerning, you should keep in mind that FormFactor has net cash of US$226.8m, as well as more liquid assets than liabilities. The cherry on top was that in converted 141% of that EBIT to free cash flow, bringing in US$103m. So is FormFactor's debt a risk? It doesn't seem so to us. Another factor that would give us confidence in FormFactor would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.