Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. Importantly, Mastercard Incorporated (NYSE:MA) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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. 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 think about a company’s use of debt, we first look at cash and debt together.

What Is Mastercard’s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2021 Mastercard had US$13.0b of debt, an increase on US$12.5b, over one year. However, it does have US$7.74b in cash offsetting this, leading to net debt of about US$5.28b.

How Strong Is Mastercard’s Balance Sheet?

We can see from the most recent balance sheet that Mastercard had liabilities of US$11.5b falling due within a year, and liabilities of US$16.9b due beyond that. Offsetting these obligations, it had cash of US$7.74b as well as receivables valued at US$4.33b due within 12 months. So it has liabilities totalling US$16.3b more than its cash and near-term receivables, combined.

Of course, Mastercard has a titanic market capitalization of US$369.6b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Mastercard has a very light debt load indeed.

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).

Mastercard’s net debt is only 0.60 times its EBITDA. And its EBIT easily covers its interest expense, being 19.9 times the size. So we’re pretty relaxed about its super-conservative use of debt. But the bad news is that Mastercard has seen its EBIT plunge 16% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Mastercard’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.

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, Mastercard produced sturdy free cash flow equating to 76% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Mastercard’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But the stark truth is that we are concerned by its EBIT growth rate. Taking all this data into account, it seems to us that Mastercard takes a pretty sensible approach to 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. But ultimately, every company can contain risks that exist outside of the balance sheet.