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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Apple Inc. (NASDAQ:AAPL) does carry debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
View our latest analysis for Apple
What Is Apple’s Debt?
The chart below, which you can click on for greater detail, shows that Apple had US$112.7b in debt in June 2020; about the same as the year before. However, it does have US$93.0b in cash offsetting this, leading to net debt of about US$19.7b.
How Strong Is Apple’s Balance Sheet?
The latest balance sheet data shows that Apple had liabilities of US$95.3b due within a year, and liabilities of US$149.7b falling due after that. Offsetting these obligations, it had cash of US$93.0b as well as receivables valued at US$32.1b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$120.0b.
Of course, Apple has a titanic market capitalization of US$1.92t, 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. But either way, Apple has virtually no net debt, so it’s fair to say it does not have a heavy debt load!
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Apple has a low debt to EBITDA ratio of only 0.25. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there’s no doubt this company can take on debt while staying cool as a cucumber. The good news is that Apple has increased its EBIT by 4.2% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Apple’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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Apple recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
Our View
The good news is that Apple’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Zooming out, Apple seems to use debt quite reasonably; and that gets the nod from us. 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. However, not all investment risk resides within the balance sheet – far from it. To that end, you should be aware of the 2 warning signs we’ve spotted with Apple .
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. 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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