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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that MACOM Technology Solutions Holdings, Inc. (NASDAQ:MTSI) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is MACOM Technology Solutions Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that MACOM Technology Solutions Holdings had US$494.5m of debt in July 2021, down from US$659.8m, one year before. However, it also had US$308.9m in cash, and so its net debt is US$185.6m.
A Look At MACOM Technology Solutions Holdings' Liabilities
Zooming in on the latest balance sheet data, we can see that MACOM Technology Solutions Holdings had liabilities of US$87.1m due within 12 months and liabilities of US$567.2m due beyond that. Offsetting these obligations, it had cash of US$308.9m as well as receivables valued at US$71.6m due within 12 months. So its liabilities total US$273.8m more than the combination of its cash and short-term receivables.
Of course, MACOM Technology Solutions Holdings has a market capitalization of US$4.55b, 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.
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).
While MACOM Technology Solutions Holdings's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.3 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that MACOM Technology Solutions Holdings improved its EBIT from a last year's loss to a positive US$67m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if MACOM Technology Solutions Holdings 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, MACOM Technology Solutions Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our View
MACOM Technology Solutions Holdings's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its interest cover. All these things considered, it appears that MACOM Technology Solutions Holdings can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. Case in point: We've spotted 3 warning signs for MACOM Technology Solutions Holdings 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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