Legendary fund manager Li Lu (who Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. 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. Like many other companies Switch, Inc. (NYSE: SWCH) uses debt. But the real question is whether this debt makes the business risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own 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. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is Switch’s net debt?
You can click on the graph below for historical numbers, but it shows that in March 2021, Switch had a debt of US $ 1.02 billion, an increase from US $ 850.8 million, over a year. However, given that it has a cash reserve of $ 38.9 million, its net debt is less, at around $ 977.1 million.
A look at the responsibilities of Switch
The latest balance sheet data shows that Switch had liabilities of US $ 109.1 million due within one year and liabilities of US $ 1.43 billion due after that. In return, he had $ 38.9 million in cash and $ 21.2 million in receivables due within 12 months. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by $ 1.48 billion.
While that might sound like a lot, it’s not that bad since Switch has a market cap of $ 5.27 billion, and therefore could likely strengthen its balance sheet by raising capital if needed. But we absolutely want to keep our eyes open for indications that its debt is too risky.
We measure a company’s debt load relative to its earning capacity 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.
Switch’s debt is 3.9 times its EBITDA, and its EBIT covers its interest expense 2.9 times. This suggests that while debt levels are significant, we would stop calling them problematic. On a slightly more positive note, Switch increased its EBIT to 16% over the past year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Switch can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Switch has seen substantial total negative free cash flow. While investors no doubt expect this situation to reverse in due course, it clearly means that its use of debt is riskier.
Our point of view
Switch’s struggle to convert EBIT to free cash flow made us guess at the strength of its balance sheet, but the other data points we considered were relatively interesting. But on the bright side, its ability to increase its EBIT is not at all shabby. When we consider all the factors mentioned, it seems to us that Switch is taking risks with its recourse to debt. So while this leverage increases returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. For example, we have identified 3 warning signs for Switch (1 is a bit of a concern) you should be aware of.
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash net growth stocks.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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