Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Microsoft Corporation (NASDAQ:MSFT) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
How Much Debt Does Microsoft Carry?
The image below, which you can click on for greater detail, shows that Microsoft had debt of US$58.1b at the end of June 2021, a reduction from US$63.3b over a year. However, it does have US$130.3b in cash offsetting this, leading to net cash of US$72.1b.
A Look At Microsoft's Liabilities
According to the last reported balance sheet, Microsoft had liabilities of US$88.7b due within 12 months, and liabilities of US$103.1b due beyond 12 months. Offsetting this, it had US$130.3b in cash and US$38.0b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$23.5b.
This state of affairs indicates that Microsoft's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the US$2.14t company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, Microsoft also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, Microsoft grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Microsoft's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Microsoft may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Microsoft generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Summing up
While it is always sensible to look at a company's total liabilities, it is very reassuring that Microsoft has US$72.1b in net cash. And it impressed us with free cash flow of US$56b, being 84% of its EBIT. So is Microsoft's debt a risk? It doesn't seem so to us. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Microsoft you should know about.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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