The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘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 note that Adobe Inc. (NASDAQ:ADBE) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.
How Much Debt Does Adobe Carry?
As you can see below, Adobe had US$4.12b of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. But it also has US$5.80b in cash to offset that, meaning it has US$1.68b net cash.
How Healthy Is Adobe’s Balance Sheet?
The latest balance sheet data shows that Adobe had liabilities of US$6.93b due within a year, and liabilities of US$5.51b falling due after that. Offsetting this, it had US$5.80b in cash and US$1.88b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.77b.
Having regard to Adobe’s size, it seems that its liquid assets are well balanced with its total liabilities. So while it’s hard to imagine that the US$243.0b company is struggling for cash, we still think it’s worth monitoring its balance sheet. While it does have liabilities worth noting, Adobe also has more cash than debt, so we’re pretty confident it can manage its debt safely.
On top of that, Adobe grew its EBIT by 36% 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 Adobe can strengthen its balance sheet over time.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Adobe 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. Over the last three years, Adobe actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Summing up
While it is always sensible to look at a company’s total liabilities, it is very reassuring that Adobe has US$1.68b in net cash. The cherry on top was that in converted 120% of that EBIT to free cash flow, bringing in US$6.6b. So is Adobe’s debt a risk? It doesn’t seem so to us. There’s no doubt that we learn most about debt from the balance sheet.