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. We can see that KLA Corporation (NASDAQ:KLAC) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is KLA’s Debt?
As you can see below, KLA had US$3.44b of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$2.44b in cash, and so its net debt is US$999.4m.
How Healthy Is KLA’s Balance Sheet?
According to the last reported balance sheet, KLA had liabilities of US$2.03b due within 12 months, and liabilities of US$4.80b due beyond 12 months. Offsetting these obligations, it had cash of US$2.44b as well as receivables valued at US$1.30b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.08b.
Since publicly traded KLA shares are worth a very impressive total of US$47.8b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
KLA has a low net debt to EBITDA ratio of only 0.39. And its EBIT covers its interest expense a whopping 16.3 times over. So we’re pretty relaxed about its super-conservative use of debt. In addition to that, we’re happy to report that KLA has boosted its EBIT by 41%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if KLA can strengthen its balance sheet over time.
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. During the last three years, KLA generated free cash flow amounting to a very robust 85% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Our View
KLA’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. We think KLA is no more beholden to its lenders, than the birds are to birdwatchers. For investing nerds like us its balance sheet is almost charming. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it.