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.” So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We note that Switch, Inc. (NYSE: SWCH) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital intensive businesses. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
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How much debt does the switch carry?
You can click on the graph below for the historical numbers, but it shows that as of June 2021, Switch had a debt of US $ 1.51 billion, an increase from US $ 871.7 million, over a year. However, because it has a cash reserve of US $ 84.8 million, its net debt is less, at around US $ 1.43 billion.
How healthy is Switch’s track record?
Zooming in on the latest balance sheet data, we can see that Switch had a liability of US $ 158.1 million owed within 12 months and a liability of US $ 1.95 billion owed beyond that. On the other hand, he had $ 84.8 million in cash and $ 32.1 million in receivables due within one year. Its liabilities therefore total US $ 1.99 billion more than the combination of its cash and short-term receivables.
This shortfall is not that big of a deal as Switch is worth $ 6.12 billion, so it could probably raise enough capital to consolidate its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Switch has a rather high debt-to-EBITDA ratio of 5.5, which suggests significant leverage. However, its interest coverage of 2.8 is reasonably strong, which is a good sign. On a slightly more positive note, Switch increased its EBIT to 14% from last year, further increasing its ability to manage debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Switch can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Switch has seen substantial total negative free cash flow. While this may be the result of spending on growth, it makes debt much riskier.
Our point of view
To be frank, Switch’s net debt to EBITDA and track record of converting EBIT to free cash flow makes us rather uncomfortable with its debt levels. But at least it’s decent enough to increase your EBIT; it’s encouraging. Looking at the balance sheet and taking all of these factors into account, we think debt makes the Switch stock a bit risky. Some people like this kind of risk, but we are aware of the potential pitfalls, so we would probably prefer him to carry less debt. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. We have identified 3 warning signs with Switch (at least 1 which cannot be ignored), and understanding them should be part of your investment process.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
This Simply Wall St article 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 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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