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 International Business Machines Corporation (NYSE:IBM) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 International Business Machines's Debt?
The image below, which you can click on for greater detail, shows that International Business Machines had debt of US$55.2b at the end of June 2021, a reduction from US$64.5b over a year. However, it does have US$7.95b in cash offsetting this, leading to net debt of about US$47.2b.
How Strong Is International Business Machines' Balance Sheet?
The latest balance sheet data shows that International Business Machines had liabilities of US$36.6b due within a year, and liabilities of US$88.1b falling due after that. Offsetting this, it had US$7.95b in cash and US$7.63b in receivables that were due within 12 months. So it has liabilities totalling US$109.2b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its very significant market capitalization of US$125.7b, so it does suggest shareholders should keep an eye on International Business Machines' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
International Business Machines has net debt to EBITDA of 2.8 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 9.0 suggests it can easily service that debt. One way International Business Machines could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 10%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine International Business Machines's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. Happily for any shareholders, International Business Machines actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
When it comes to the balance sheet, the standout positive for International Business Machines was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that International Business Machines is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 4 warning signs we've spotted with International Business Machines .
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.
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