The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. Importantly, Ubiquiti Inc. (NYSE:UI) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Ubiquiti’s Debt?
As you can see below, Ubiquiti had US$490.9m of debt at June 2021, down from US$652.5m a year prior. On the flip side, it has US$250.7m in cash leading to net debt of about US$240.2m.
A Look At Ubiquiti’s Liabilities
We can see from the most recent balance sheet that Ubiquiti had liabilities of US$276.4m falling due within a year, and liabilities of US$611.9m due beyond that. Offsetting these obligations, it had cash of US$250.7m as well as receivables valued at US$172.3m due within 12 months. So its liabilities total US$465.3m more than the combination of its cash and short-term receivables.
Since publicly traded Ubiquiti shares are worth a very impressive total of US$19.3b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. Carrying virtually no net debt, Ubiquiti 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).
Ubiquiti’s net debt is only 0.32 times its EBITDA. And its EBIT easily covers its interest expense, being 49.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we’re happy to report that Ubiquiti has boosted its EBIT by 55%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Ubiquiti’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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Ubiquiti recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that Ubiquiti’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! It looks Ubiquiti has no trouble standing on its own two feet, and it has no reason to fear its lenders. For investing nerds like us its balance sheet is almost charming. The balance sheet is clearly the area to focus on when you are analysing debt.