Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 ON Semiconductor Corporation (NASDAQ:ON) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 ON Semiconductor Carry?
The chart below, which you can click on for greater detail, shows that ON Semiconductor had US$3.21b in debt in July 2022; about the same as the year before. However, because it has a cash reserve of US$1.83b, its net debt is less, at about US$1.39b.
How Healthy Is ON Semiconductor’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that ON Semiconductor had liabilities of US$1.71b due within 12 months and liabilities of US$3.67b due beyond that. Offsetting this, it had US$1.83b in cash and US$1.14b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.41b.
Since publicly traded ON Semiconductor shares are worth a very impressive total of US$27.0b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
ON Semiconductor has a low net debt to EBITDA ratio of only 0.49. And its EBIT covers its interest expense a whopping 21.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that ON Semiconductor grew its EBIT by 203% over twelve months. That boost will make it even easier to pay down debt going forward. 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 ON Semiconductor’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, ON Semiconductor produced sturdy free cash flow equating to 67% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
The good news is that ON Semiconductor’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Overall, we don’t think ON Semiconductor is taking any bad risks, as its debt load seems modest. So we’re not worried about the use of a little leverage on the balance sheet.