Ultra Clean Holdings (NASDAQ:UCTT) Takes On Some Risk With Its Use Of Debt

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. We can see that Ultra Clean Holdings, Inc. (NASDAQ:UCTT) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Ultra Clean Holdings

What Is Ultra Clean Holdings's Debt?

The chart below, which you can click on for greater detail, shows that Ultra Clean Holdings had US$492.2m in debt in September 2024; about the same as the year before. However, it does have US$318.2m in cash offsetting this, leading to net debt of about US$174.0m.

How Healthy Is Ultra Clean Holdings' Balance Sheet?

We can see from the most recent balance sheet that Ultra Clean Holdings had liabilities of US$358.8m falling due within a year, and liabilities of US$666.3m due beyond that. Offsetting these obligations, it had cash of US$318.2m as well as receivables valued at US$228.1m due within 12 months. So it has liabilities totalling US$478.8m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Ultra Clean Holdings is worth US$1.62b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Given net debt is only 1.2 times EBITDA, it is initially surprising to see that Ultra Clean Holdings's EBIT has low interest coverage of 1.7 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly Ultra Clean Holdings's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Ultra Clean Holdings 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. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Ultra Clean Holdings created free cash flow amounting to 9.0% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Ultra Clean Holdings's interest cover was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its net debt to EBITDA is relatively strong. When we consider all the factors discussed, it seems to us that Ultra Clean Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Ultra Clean Holdings you should be aware of.

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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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.