Is Microchip Technology (NASDAQ:MCHP) A Risky Investment?
Simply Wall St · 01/29 10:49

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Microchip Technology Incorporated (NASDAQ:MCHP) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Microchip Technology

What Is Microchip Technology's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Microchip Technology had US$6.08b of debt in September 2023, down from US$7.30b, one year before. However, it does have US$256.6m in cash offsetting this, leading to net debt of about US$5.82b.

debt-equity-history-analysis
NasdaqGS:MCHP Debt to Equity History January 29th 2024

A Look At Microchip Technology's Liabilities

The latest balance sheet data shows that Microchip Technology had liabilities of US$3.41b due within a year, and liabilities of US$6.22b falling due after that. Offsetting these obligations, it had cash of US$256.6m as well as receivables valued at US$1.71b due within 12 months. So it has liabilities totalling US$7.67b more than its cash and near-term receivables, combined.

Of course, Microchip Technology has a titanic market capitalization of US$47.0b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Microchip Technology has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 18.3 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Microchip Technology grew its EBIT by 37% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Microchip Technology can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Microchip Technology actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

The good news is that Microchip Technology'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 conversion of EBIT to free cash flow is also very heartening. Overall, we don't think Microchip Technology 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Microchip Technology has 2 warning signs (and 1 which can't be ignored) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.