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.’ 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. We can see that Microchip Technology Incorporated (NASDAQ:MCHP) 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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.

What Is Microchip Technology’s Net Debt?

You can click the graphic below for the historical numbers, but it shows that Microchip Technology had US$8.53b of debt in June 2021, down from US$9.33b, one year before. On the flip side, it has US$279.7m in cash leading to net debt of about US$8.25b.

A Look At Microchip Technology’s Liabilities

The latest balance sheet data shows that Microchip Technology had liabilities of US$1.09b due within a year, and liabilities of US$9.67b falling due after that. Offsetting these obligations, it had cash of US$279.7m as well as receivables valued at US$1.00b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$9.48b.

Microchip Technology has a very large market capitalization of US$44.4b, 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 measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

Microchip Technology has a debt to EBITDA ratio of 3.6 and its EBIT covered its interest expense 3.5 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Looking on the bright side, Microchip Technology boosted its EBIT by a silky 59% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing 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 Microchip Technology’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Microchip Technology actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Microchip Technology’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. When we consider the range of factors above, it looks like Microchip Technology is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start.