Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Analog Devices, Inc. (NASDAQ:ADI) does use debt in its business. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. The first step when considering a company’s debt levels is to consider its cash and debt together.

What Is Analog Devices’s Debt?

You can click the graphic below for the historical numbers, but it shows that Analog Devices had US$4.95b of debt in May 2021, down from US$5.84b, one year before. On the flip side, it has US$1.31b in cash leading to net debt of about US$3.65b.

How Healthy Is Analog Devices’ Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Analog Devices had liabilities of US$2.78b due within 12 months and liabilities of US$6.64b due beyond that. Offsetting this, it had US$1.31b in cash and US$814.1m in receivables that were due within 12 months. So its liabilities total US$7.30b more than the combination of its cash and short-term receivables.

Of course, Analog Devices has a titanic market capitalization of US$60.8b, 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.

In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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 is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 11.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Analog Devices grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Analog Devices’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. Happily for any shareholders, Analog Devices actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Analog Devices’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. And the good news does not stop there, as its EBIT growth rate also supports that impression! Considering this range of factors, it seems to us that Analog Devices 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet.