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. Importantly, Microchip Technology Incorporated (NASDAQ:MCHP) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Microchip Technology
What Is Microchip Technology's Net Debt?
As you can see below, Microchip Technology had US$10.1b of debt at June 2019, down from US$11.3b a year prior. On the flip side, it has US$437.1m in cash leading to net debt of about US$9.65b.
A Look At Microchip Technology's Liabilities
The latest balance sheet data shows that Microchip Technology had liabilities of US$2.45b due within a year, and liabilities of US$10.5b falling due after that. Offsetting this, it had US$437.1m in cash and US$936.8m in receivables that were due within 12 months. So it has liabilities totalling US$11.6b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Microchip Technology has a huge market capitalization of US$22.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn't worry about Microchip Technology's net debt to EBITDA ratio of 4.7, we think its super-low interest cover of 1.9 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that Microchip Technology improved its EBIT by 4.0% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Microchip Technology 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, Microchip Technology actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our View
When it comes to the balance sheet, the standout positive for Microchip Technology was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. In particular, interest cover gives us cold feet. Looking at all this data makes us feel a little cautious about Microchip Technology's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Microchip Technology insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.