Here's Why Ultra Clean Holdings (NASDAQ:UCTT) Can Manage Its Debt Responsibly

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.' 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. As with many other companies Ultra Clean Holdings, Inc. (NASDAQ:UCTT) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Ultra Clean Holdings

How Much Debt Does Ultra Clean Holdings Carry?

As you can see below, Ultra Clean Holdings had US$546.3m of debt at July 2022, down from US$594.7m a year prior. However, it also had US$421.4m in cash, and so its net debt is US$124.9m.

How Healthy Is Ultra Clean Holdings' Balance Sheet?

The latest balance sheet data shows that Ultra Clean Holdings had liabilities of US$395.4m due within a year, and liabilities of US$654.5m falling due after that. Offsetting this, it had US$421.4m in cash and US$243.8m in receivables that were due within 12 months. So it has liabilities totalling US$384.7m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Ultra Clean Holdings has a market capitalization of US$1.26b, 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Ultra Clean Holdings has net debt of just 0.41 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.6 times the interest expense over the last year. In addition to that, we're happy to report that Ultra Clean Holdings has boosted its EBIT by 63%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Ultra Clean Holdings's ability to maintain a healthy balance sheet going forward. 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. Looking at the most recent three years, Ultra Clean Holdings recorded free cash flow of 48% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Ultra Clean Holdings's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Taking all this data into account, it seems to us that Ultra Clean Holdings takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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 Ultra Clean Holdings 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.