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Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. It is only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We can see that International Business Machines Corporation (NYSE: IBM) uses debt in its business. But should shareholders be concerned about its use of debt?
When is debt a problem?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
Check out our latest review for International Business Machines
What is International Business Machines debt?
The image below, which you can click for more details, shows that International Business Machines had $ 55.2 billion in debt at the end of June 2021, a reduction from $ 64.5 billion. of US dollars over one year. However, it has US $ 7.95 billion in cash offsetting this, leading to net debt of around US $ 47.2 billion.
How strong is International Business Machines’ balance sheet?
The latest balance sheet data shows that International Business Machines had liabilities of US $ 36.6 billion due within one year, and liabilities of US $ 88.1 billion due thereafter. In return, he had $ 7.95 billion in cash and $ 7.63 billion in receivables due within 12 months. It therefore has liabilities totaling US $ 109.2 billion more than its cash and short-term receivables combined.
This shortfall is sizable compared to its very large market capitalization of US $ 125.7 billion, so he suggests shareholders keep an eye on International Business Machines’ use of debt. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
International Business Machines has a net debt to EBITDA of 2.8, which suggests that it is using a little leverage to increase returns. But the high interest coverage of 9.0 suggests that he can easily pay off that debt. One way that International Business Machines could beat its debt would be to stop borrowing more but continue to increase its EBIT by around 10%, as it did last year. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future profits, more than anything, that will determine International Business Machines’ ability to maintain a healthy balance sheet in the future. So if you are focused on the future you can check this out free report showing analysts‘ earnings forecasts.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Fortunately for all shareholders, International Business Machines has actually generated more free cash flow than EBIT over the past three years. This kind of cash conversion makes us as excited as the crowd when the pace drops at a Daft Punk concert.
Our point of view
When it comes to the balance sheet, the good thing about International Business Machines is that it appears to be able to convert EBIT to free cash flow with confidence. However, our other observations were not so encouraging. For example, his total liability level makes us a little nervous about his debt. When we consider all the elements mentioned above, it seems to us that International Business Machines is managing its debt quite well. But beware: we believe debt levels are high enough to warrant continued monitoring. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist off the balance sheet. To do this, you need to know the 4 warning signs we spotted with International Business Machines.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash growth stocks today.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St does not have any position in the mentioned stocks.
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