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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Fortinet, Inc. (NASDAQ:FTNT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 step when considering a company’s debt levels is to consider its cash and debt together.
What Is Fortinet’s Net Debt?
The image below, which you can click on for greater detail, shows that at March 2021 Fortinet had debt of US$987.0m, up from none in one year. But on the other hand it also has US$2.94b in cash, leading to a US$1.95b net cash position.
How Healthy Is Fortinet’s Balance Sheet?
According to the last reported balance sheet, Fortinet had liabilities of US$1.88b due within 12 months, and liabilities of US$2.42b due beyond 12 months. Offsetting these obligations, it had cash of US$2.94b as well as receivables valued at US$639.9m due within 12 months. So its liabilities total US$724.6m more than the combination of its cash and short-term receivables.
Since publicly traded Fortinet shares are worth a very impressive total of US$32.2b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Fortinet 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 Fortinet has boosted its EBIT by 40%, thus reducing the spectre of future debt repayments. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Fortinet can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Fortinet 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, Fortinet actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
We could understand if investors are concerned about Fortinet’s liabilities, but we can be reassured by the fact it has has net cash of US$1.95b. The cherry on top was that in converted 206% of that EBIT to free cash flow, bringing in US$930m. So we don’t think Fortinet’s use of debt is risky. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet.