Palo Alto Networks (NASDAQ:PANW) Seems To Use Debt Quite Sensibly

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. We can see that Palo Alto Networks, Inc. (NASDAQ:PANW) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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. 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.

View our latest analysis for Palo Alto Networks

What Is Palo Alto Networks's Net Debt?

As you can see below, Palo Alto Networks had US$3.68b of debt, at January 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$3.35b in cash, and so its net debt is US$333.4m.

How Healthy Is Palo Alto Networks' Balance Sheet?

According to the last reported balance sheet, Palo Alto Networks had liabilities of US$8.48b due within 12 months, and liabilities of US$3.96b due beyond 12 months. Offsetting these obligations, it had cash of US$3.35b as well as receivables valued at US$1.28b due within 12 months. So it has liabilities totalling US$7.81b more than its cash and near-term receivables, combined.

Of course, Palo Alto Networks has a titanic market capitalization of US$60.3b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Carrying virtually no net debt, Palo Alto Networks has a very light debt load indeed.

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.

Palo Alto Networks has a low debt to EBITDA ratio of only 1.4. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. It was also good to see that despite losing money on the EBIT line last year, Palo Alto Networks turned things around in the last 12 months, delivering and EBIT of US$23m. 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 Palo Alto Networks 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.

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 the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Palo Alto Networks actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Palo Alto Networks's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think Palo Alto Networks's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. To that end, you should be aware of the 3 warning signs we've spotted with Palo Alto Networks .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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