Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” It’s only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. Mostly, Broadcom Inc. (NASDAQ: AVGO) is in debt. But does this debt worry shareholders?
What risk does debt entail?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, many companies use debt to finance their growth without negative consequences. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
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What is Broadcom’s debt?
As you can see below, Broadcom had $ 40.4 billion in debt in May 2021, up from $ 45.8 billion the year before. However, he also had $ 9.52 billion in cash, so his net debt is $ 30.9 billion.
Is Broadcom’s Balance Sheet Healthy?
We can see from the most recent balance sheet that Broadcom had liabilities of US $ 6.44 billion maturing within one year and liabilities of US $ 45.1 billion maturing beyond that. On the other hand, he had US $ 9.52 billion in cash and US $ 2.43 billion in receivables due within one year. As a result, it has liabilities totaling US $ 39.6 billion more than its cash and short-term receivables combined.
Broadcom has a very large market cap of $ 196.5 billion, so it could most likely raise funds to improve its balance sheet, should the need arise. However, it is always worth taking a close look at your ability to repay debts.
We measure a company’s debt load relative to its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). Thus, we consider debt versus earnings with and without amortization charges.
Broadcom has net debt worth 2.4 times EBITDA, which isn’t too much, but its interest coverage looks a bit low, with EBIT at just 3.5 times interest expense. . While we’re not worried about these numbers, it’s worth noting that the company’s cost of debt does have a real impact. It should be noted that Broadcom’s EBIT has soared like bamboo after the rain, gaining 78% in the past twelve months. This will make it easier to manage your debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future profits, more than anything, that will determine Broadcom’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 analyst earnings forecast report interesting.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, Broadcom has actually generated more free cash flow than EBIT. This kind of strong cash generation warms our hearts like a puppy in a bumblebee costume.
Our point of view
Fortunately, Broadcom’s impressive conversion of EBIT to free cash flow means it has the upper hand over its debt. But frankly, we think his interest in the cover shakes that impression a bit. Given all of this data, it seems to us that Broadcom is taking a fairly reasonable approach to debt. While this carries some risk, it can also improve returns for shareholders. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 3 warning signs for Broadcom you should know.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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