Yahoo Finance Here's Why Analog Devices (NASDAQ:ADI) Can Manage Its Debt Responsibly
Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Analog Devices, Inc. (NASDAQ:ADI) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Analog Devices
What Is Analog Devices's Net Debt?
As you can see below, Analog Devices had US$6.04b of debt at May 2019, down from US$6.98b a year prior. However, because it has a cash reserve of US$713.6m, its net debt is less, at about US$5.32b.
How Healthy Is Analog Devices's Balance Sheet?
We can see from the most recent balance sheet that Analog Devices had liabilities of US$1.37b falling due within a year, and liabilities of US$8.67b due beyond that. On the other hand, it had cash of US$713.6m and US$686.0m worth of receivables due within a year. So it has liabilities totalling US$8.63b more than its cash and near-term receivables, combined.
Analog Devices has a very large market capitalization of US$42.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Analog Devices's net debt of 2.0 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.3 times its interest expenses harmonizes with that theme. Notably Analog Devices's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Analog Devices can strengthen its balance sheet over time. 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. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Analog Devices recorded free cash flow worth a fulsome 92% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Our View
Happily, Analog Devices's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And its interest cover is good too. Looking at all the aforementioned factors together, it strikes us that Analog Devices can handle its debt fairly comfortably. 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. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Analog Devices insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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