Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘volatility is far from synonymous with risk.’ So it may be obvious that you need to consider debt, when you think about how risky any stock is, because too much debt can sink a company. Importantly, Broadcom Inc. (NASDAQ: AVGO ) borrows. But is this debt a concern for shareholders?
Why is debt risky?
A loan supports a business until the business has trouble making payments, either with new capital or free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failing businesses are ruthlessly destroyed by their bankers. Although it is not very common, we often see indebted companies permanently diluting shareholders because creditors force them to raise capital at distressed prices. Of course, debt can be an important tool in businesses, especially capital-heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
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What is Broadcom’s net debt?
The chart below, which you can click on for more details, shows that Broadcom had US$39.3b in debt in January 2023; Almost the same as last year. However, it also had US$12.6b in cash, and so its net debt is US$26.7b.
How strong is Broadcom’s balance sheet?
We can see from the latest balance sheet that Broadcom has liabilities of US$7.48b reduced within a year, and liabilities of US$42.2b beyond that. Offsetting this, it had US$12.6b of cash and US$3.23b of receivables due within 12 months. So its liabilities exceed its cash and (near-term) receivables by US$33.8b.
As publicly traded Broadcom shares are worth a very impressive total of US$258.3b, this level of liabilities is unlikely to be a major threat. But there are enough liabilities that we would certainly recommend that shareholders continue to monitor the balance sheet, going forward.
To size a company’s debt relative to its earnings, we calculate earnings before interest, taxes, depreciation, and amortization (EBITDA) and earnings before interest and taxes (EBIT) divided by its interest expense (EBIT). its interest cover). Thus we consider debt relative to income both with and without depreciation and amortization expense.
With net debt sitting at just 1.3 times EBITDA, Broadcom is arguably geared very conservatively. And it boasts of an interest cover of 9.3 times, which is more than adequate. In addition, we are pleased to report that Broadcom has increased its EBIT by 55%, thereby reducing the likelihood of future debt repayments. When analyzing debt levels, the balance sheet is an obvious place to start. But ultimately the future profitability of the business will decide whether Broadcom can strengthen its balance sheet over time. So if you are focused on the future you can check it out for free Report showing analyst profit forecast.
Finally, a business needs free cash flow to pay off debt; Accounting profit just doesn’t cut it. So the logical step is to look at the ratio of EBIT that corresponds to actual free cash flow. Happily for any shareholders, Broadcom actually generated more free cash flow than EBIT over the past three years. Nothing beats incoming cash when it comes to staying in your lender’s good graces.
Happily, Broadcom’s impressive conversion of EBIT to free cash flow indicates that its debt has the upper hand. And the good news doesn’t stop there, as its EBIT growth rate also supports that impression! Overall, we don’t think Broadcom is taking on a bad risk, as its debt load looks modest. So we are not concerned about using a little leverage on the balance sheet. When analyzing debt levels, the balance sheet is an obvious place to start. However, not all investment risk stays within the balance sheet – far from it. These risks can be difficult to detect. Every company has them, and we’ve seen them 3 warning signs for Broadcom You should know.
Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then don’t hesitate to explore our exclusive list of pure cash growth stocks today.
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This article by Simply Wall St. is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not recommend buying or selling any stock, and does not take into account your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative content. Simply Wall St. has no position in any of the stocks mentioned.