David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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 VMware, Inc. (NYSE:VMW) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does VMware Carry?

You can click the graphic below for the historical numbers, but it shows that VMware had US$4.99b of debt in April 2021, down from US$7.73b, one year before. However, its balance sheet shows it holds US$5.71b in cash, so it actually has US$725.0m net cash.

How Healthy Is VMware’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that VMware had liabilities of US$7.85b due within 12 months and liabilities of US$11.5b due beyond that. Offsetting this, it had US$5.71b in cash and US$2.33b in receivables that were due within 12 months. So its liabilities total US$11.3b more than the combination of its cash and short-term receivables.

Since publicly traded VMware shares are worth a very impressive total of US$66.1b, 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. Despite its noteworthy liabilities, VMware boasts net cash, so it’s fair to say it does not have a heavy debt load!

Another good sign is that VMware has been able to increase its EBIT by 28% in twelve months, making it easier to pay down debt. 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 VMware can strengthen its balance sheet over time.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. VMware 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, VMware actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.

Summing up

While VMware does have more liabilities than liquid assets, it also has net cash of US$725.0m. And it impressed us with free cash flow of US$4.0b, being 189% of its EBIT. So is VMware’s debt a risk? It doesn’t seem so to us. When analysing debt levels, the balance sheet is the obvious place to start.