Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. We note that NXP Semiconductors N.V. (NASDAQ:NXPI) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is NXP Semiconductors’s Net Debt?
As you can see below, at the end of April 2022, NXP Semiconductors had US$10.6b of debt, up from US$7.61b a year ago. Click the image for more detail. However, it does have US$2.68b in cash offsetting this, leading to net debt of about US$7.89b.
How Healthy Is NXP Semiconductors’ Balance Sheet?
We can see from the most recent balance sheet that NXP Semiconductors had liabilities of US$2.85b falling due within a year, and liabilities of US$11.7b due beyond that. On the other hand, it had cash of US$2.68b and US$925.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$11.0b.
This deficit isn’t so bad because NXP Semiconductors is worth a massive US$41.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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.
NXP Semiconductors’s net debt of 1.9 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.8 times its interest expenses harmonizes with that theme. Pleasingly, NXP Semiconductors is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 206% gain in the last twelve months. 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 NXP Semiconductors’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, NXP Semiconductors actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
Our View
Happily, NXP Semiconductors’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Zooming out, NXP Semiconductors seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start.