The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. As with many other companies Chegg, Inc. (NYSE:CHGG) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. 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 examine debt levels, we first consider both cash and debt levels, together.

What Is Chegg’s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2021 Chegg had US$1.67b of debt, an increase on US$913.2m, over one year. But on the other hand it also has US$1.87b in cash, leading to a US$198.2m net cash position.

How Healthy Is Chegg’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chegg had liabilities of US$251.1m due within 12 months and liabilities of US$1.70b due beyond that. Offsetting this, it had US$1.87b in cash and US$11.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$66.5m.

This state of affairs indicates that Chegg’s balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it’s very unlikely that the US$10.9b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, Chegg also has more cash than debt, so we’re pretty confident it can manage its debt safely.

Pleasingly, Chegg is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 216% 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 Chegg’s ability to maintain a healthy balance sheet going forward.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Chegg 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 last two years, Chegg actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While it is always sensible to look at a company’s total liabilities, it is very reassuring that Chegg has US$198.2m in net cash. And it impressed us with free cash flow of US$140m, being 221% of its EBIT. So we don’t think Chegg’s use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet.