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. Importantly, Agilent Technologies, Inc. (NYSE:A) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Agilent Technologies’s Net Debt?

The chart below, which you can click on for greater detail, shows that Agilent Technologies had US$2.91b in debt in April 2022; about the same as the year before. However, it also had US$1.21b in cash, and so its net debt is US$1.70b.

How Strong Is Agilent Technologies’ Balance Sheet?

The latest balance sheet data shows that Agilent Technologies had liabilities of US$1.81b due within a year, and liabilities of US$3.52b falling due after that. Offsetting these obligations, it had cash of US$1.21b as well as receivables valued at US$1.24b due within 12 months. So its liabilities total US$2.89b more than the combination of its cash and short-term receivables.

Given Agilent Technologies has a humongous market capitalization of US$33.7b, it’s hard to believe these liabilities pose much threat. 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).

Agilent Technologies’s net debt is only 0.92 times its EBITDA. And its EBIT covers its interest expense a whopping 18.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Agilent Technologies grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. 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 Agilent Technologies’s ability to maintain a healthy balance sheet going forward.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Agilent Technologies recorded free cash flow worth a fulsome 80% 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 Agilent Technologies’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Considering this range of factors, it seems to us that Agilent Technologies is quite prudent with its debt, and the risks seem well managed. So we’re not worried about the use of a little leverage on the balance sheet. There’s no doubt that we learn most about debt from the balance sheet.