David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 MicroStrategy Incorporated (NASDAQ:MSTR) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is MicroStrategy's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2021 MicroStrategy had debt of US$2.16b, up from US$486.4m in one year. However, it does have US$63.4m in cash offsetting this, leading to net debt of about US$2.09b.
How Healthy Is MicroStrategy's Balance Sheet?
We can see from the most recent balance sheet that MicroStrategy had liabilities of US$312.0m falling due within a year, and liabilities of US$2.27b due beyond that. Offsetting this, it had US$63.4m in cash and US$190.4m in receivables that were due within 12 months. So it has liabilities totalling US$2.32b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since MicroStrategy has a market capitalization of US$5.13b, 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.
MicroStrategy shareholders face the double whammy of a high net debt to EBITDA ratio (36.4), and fairly weak interest coverage, since EBIT is just 1.6 times the interest expense. This means we'd consider it to have a heavy debt load. Investors should also be troubled by the fact that MicroStrategy saw its EBIT drop by 19% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. 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 MicroStrategy 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, MicroStrategy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, MicroStrategy's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to handle its total liabilities isn't such a worry. After considering the datapoints discussed, we think MicroStrategy has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for MicroStrategy (of which 1 is a bit unpleasant!) you should know about.
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.
What are the risks and opportunities for MicroStrategy?
Became profitable this year
Earnings are forecast to decline by an average of 100.1% per year for the next 3 years
Debt is not well covered by operating cash flow
High level of non-cash earnings
Shareholders have been diluted in the past year
Significant insider selling over the past 3 months
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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.