Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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 Arrow Electronics, Inc. (NYSE:ARW) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. 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, 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. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Arrow Electronics Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2021 Arrow Electronics had US$2.63b of debt, an increase on US$2.26b, over one year. However, because it has a cash reserve of US$222.2m, its net debt is less, at about US$2.40b.
How Strong Is Arrow Electronics’ Balance Sheet?
The latest balance sheet data shows that Arrow Electronics had liabilities of US$11.3b due within a year, and liabilities of US$2.87b falling due after that. On the other hand, it had cash of US$222.2m and US$11.1b worth of receivables due within a year. So its liabilities total US$2.85b more than the combination of its cash and short-term receivables.
Arrow Electronics has a market capitalization of US$8.00b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Arrow Electronics has a low net debt to EBITDA ratio of only 1.4. And its EBIT easily covers its interest expense, being 13.8 times the size. So we’re pretty relaxed about its super-conservative use of debt. On top of that, Arrow Electronics grew its EBIT by 74% over the last twelve months, and that growth will make it easier to handle its debt. 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 Arrow Electronics’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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Arrow Electronics recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Our View
Happily, Arrow Electronics’s impressive interest cover 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, Arrow Electronics seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt.
