Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Ultra Clean Holdings's Debt?
As you can see below, Ultra Clean Holdings had US$269.0m of debt at December 2020, down from US$292.2m a year prior. However, because it has a cash reserve of US$200.3m, its net debt is less, at about US$68.7m.
How Strong Is Ultra Clean Holdings' Balance Sheet?
The latest balance sheet data shows that Ultra Clean Holdings had liabilities of US$201.2m due within a year, and liabilities of US$350.1m falling due after that. Offsetting these obligations, it had cash of US$200.3m as well as receivables valued at US$145.5m due within 12 months. So its liabilities total US$205.5m more than the combination of its cash and short-term receivables.
Since publicly traded Ultra Clean Holdings shares are worth a total of US$2.30b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt sitting at just 0.41 times EBITDA, Ultra Clean Holdings is arguably pretty conservatively geared. And it boasts interest cover of 7.7 times, which is more than adequate. Better yet, Ultra Clean Holdings grew its EBIT by 190% last year, which is an impressive improvement. That boost will make it even 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 Ultra Clean Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Ultra Clean Holdings recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Happily, Ultra Clean Holdings's impressive EBIT growth rate implies it has the upper hand on its debt. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Considering this range of factors, it seems to us that Ultra Clean Holdings is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. 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. We've identified 2 warning signs with Ultra Clean Holdings , and understanding them should be part of your investment process.
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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