Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Alphabet Inc. (NASDAQ:GOOG.L) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Alphabet’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2021 Alphabet had US$13.8b of debt, an increase on US$3.96b, over one year. However, it does have US$135.1b in cash offsetting this, leading to net cash of US$121.3b.
How Strong Is Alphabet’s Balance Sheet?
The latest balance sheet data shows that Alphabet had liabilities of US$55.5b due within a year, and liabilities of US$41.6b falling due after that. Offsetting these obligations, it had cash of US$135.1b as well as receivables valued at US$28.5b due within 12 months. So it actually has US$66.5b more liquid assets than total liabilities.
This short term liquidity is a sign that Alphabet could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Alphabet boasts net cash, so it’s fair to say it does not have a heavy debt load!
In addition to that, we’re happy to report that Alphabet has boosted its EBIT by 37%, thus reducing the spectre of future debt repayments. 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 Alphabet can strengthen its balance sheet over time.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Alphabet has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Alphabet recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
Summing up
While we empathize with investors who find debt concerning, you should keep in mind that Alphabet has net cash of US$121.3b, as well as more liquid assets than liabilities. The cherry on top was that in converted 89% of that EBIT to free cash flow, bringing in US$51b. So we don’t think Alphabet’s use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start