SolarWinds (NYSE:SWI) Takes On Some Risk With Its Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 note that SolarWinds Corporation (NYSE:SWI) does have debt on its balance sheet. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for SolarWinds

What Is SolarWinds's Net Debt?

The chart below, which you can click on for greater detail, shows that SolarWinds had US$1.90b in debt in December 2020; about the same as the year before. However, it also had US$370.5m in cash, and so its net debt is US$1.53b.

A Look At SolarWinds' Liabilities

The latest balance sheet data shows that SolarWinds had liabilities of US$491.2m due within a year, and liabilities of US$2.21b falling due after that. Offsetting this, it had US$370.5m in cash and US$116.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.21b.

This deficit isn't so bad because SolarWinds is worth US$5.33b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

SolarWinds shareholders face the double whammy of a high net debt to EBITDA ratio (7.5), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. This means we'd consider it to have a heavy debt load. Another concern for investors might be that SolarWinds's EBIT fell 19% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 SolarWinds 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, SolarWinds actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both SolarWinds's EBIT growth rate and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that SolarWinds's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. To that end, you should learn about the 3 warning signs we've spotted with SolarWinds (including 2 which don't sit too well with us) .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. 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.
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