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 KLA Corporation (NASDAQ:KLAC) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is KLA's Debt?
The chart below, which you can click on for greater detail, shows that KLA had US$3.46b in debt in December 2020; about the same as the year before. However, it does have US$2.30b in cash offsetting this, leading to net debt of about US$1.16b.
How Strong Is KLA's Balance Sheet?
The latest balance sheet data shows that KLA had liabilities of US$2.02b due within a year, and liabilities of US$4.84b falling due after that. On the other hand, it had cash of US$2.30b and US$1.31b worth of receivables due within a year. So it has liabilities totalling US$3.25b more than its cash and near-term receivables, combined.
Since publicly traded KLA shares are worth a very impressive total of US$49.1b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
KLA's net debt is only 0.51 times its EBITDA. And its EBIT covers its interest expense a whopping 14.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, KLA grew its EBIT by 43% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if KLA 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, KLA recorded free cash flow worth a fulsome 85% 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 KLA's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! It looks KLA has no trouble standing on its own two feet, and it has no reason to fear its lenders. For investing nerds like us its balance sheet is almost charming. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for KLA that you should be aware of.
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.
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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