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.’ 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, Advanced Energy Industries, Inc. (NASDAQ:AEIS) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Advanced Energy Industries’s Debt?
As you can see below, Advanced Energy Industries had US$363.5m of debt at June 2023, down from US$383.0m a year prior. However, its balance sheet shows it holds US$455.4m in cash, so it actually has US$91.9m net cash.
How Healthy Is Advanced Energy Industries’ Balance Sheet?
According to the last reported balance sheet, Advanced Energy Industries had liabilities of US$303.4m due within 12 months, and liabilities of US$521.2m due beyond 12 months. On the other hand, it had cash of US$455.4m and US$258.8m worth of receivables due within a year. So it has liabilities totalling US$110.4m more than its cash and near-term receivables, combined.
Given Advanced Energy Industries has a market capitalization of US$3.31b, it’s hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Advanced Energy Industries boasts net cash, so it’s fair to say it does not have a heavy debt load!
Another good sign is that Advanced Energy Industries has been able to increase its EBIT by 25% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Advanced Energy Industries’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. Advanced Energy Industries 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 most recent three years, Advanced Energy Industries recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Summing Up
We could understand if investors are concerned about Advanced Energy Industries’s liabilities, but we can be reassured by the fact it has has net cash of US$91.9m. And it impressed us with its EBIT growth of 25% over the last year. So is Advanced Energy Industries’s debt a risk? It doesn’t seem so to us. When analysing debt levels, the balance sheet is the obvious place to start.