Legendary fund manager Li Lu (whom 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. 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 can see that FormFactor, Inc. (NASDAQ: FORM) uses debt in its business. But the real question is whether this debt makes the business risky.
What risk does debt entail?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. 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. 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 look at debt levels, we first consider both cash and debt levels.
What is FormFactor’s net debt?
As you can see below, FormFactor had a debt of US $ 29.5 million in June 2021, up from US $ 50.1 million the year before. However, it has US $ 256.2 million in cash offsetting this, which leads to a net cash position of US $ 226.8 million.
NasdaqGS: FORM History of debt to equity October 20, 2021
A look at the responsibilities of FormFactor
Zooming in on the latest balance sheet data, we can see that FormFactor had liabilities of US $ 153.9 million due within 12 months and US $ 65.1 million liabilities beyond. In compensation for these obligations, he had cash of US $ 256.2 million as well as receivables valued at US $ 111.9 million due within 12 months. He can therefore avail himself of $ 149.1 million in liquid assets more than total Liabilities.
This surplus suggests that FormFactor has a prudent balance sheet and could likely eliminate its debt without too much difficulty. In short, FormFactor has clean cash flow, so it’s fair to say it doesn’t have a lot of debt!
Another good sign is that FormFactor was able to increase its EBIT by 24% in twelve months, making it easier to pay off debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future profits, more than anything, that will determine FormFactor’s ability to maintain a healthy balance sheet in the future. 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 repay its debts; accounting profits are not enough. FormFactor may have net cash on the balance sheet, but it’s always interesting to look at the extent to which the company converts its earnings before interest and taxes (EBIT) into free cash flow, as this will influence both its need and its ability to manage debt. Over the past three years, FormFactor has actually generated more free cash flow than EBIT. There is nothing better than cash flow to stay in the good graces of your lenders.
While we sympathize with investors who find debt of concern, you should keep in mind that FormFactor has net cash of US $ 226.8 million, plus more liquid assets than liabilities. And he impressed us with free cash flow of US $ 103 million, or 141% of his EBIT. So we don’t think FormFactor’s use of debt is risky. We would be very happy to see if FormFactor insiders have recovered any stock. If you are too, click this link now to take a (free) look at our list of reported insider trades.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net growth stocks today.
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