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. As with many other companies Microsoft Corporation (NASDAQ:MSFT) 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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Microsoft Carry?
You can click the graphic below for the historical numbers, but it shows that Microsoft had US$53.3b of debt in September 2021, down from US$63.6b, one year before. But it also has US$130.6b in cash to offset that, meaning it has US$77.3b net cash.
A Look At Microsoft’s Liabilities
The latest balance sheet data shows that Microsoft had liabilities of US$80.5b due within a year, and liabilities of US$102.9b falling due after that. Offsetting this, it had US$130.6b in cash and US$27.3b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$25.5b.
This state of affairs indicates that Microsoft’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$2.57t company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Microsoft boasts net cash, so it’s fair to say it does not have a heavy debt load!
On top of that, Microsoft grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Microsoft’s ability to maintain a healthy balance sheet going forward.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. Microsoft 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 three years, Microsoft recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
Summing up
We could understand if investors are concerned about Microsoft’s liabilities, but we can be reassured by the fact it has has net cash of US$77.3b. The cherry on top was that in converted 84% of that EBIT to free cash flow, bringing in US$60b. So we don’t think Microsoft’s use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt.
