The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Alibaba Group Holding Limited (NYSE:BABA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Alibaba Group Holding's Debt?
As you can see below, Alibaba Group Holding had CN¥139.4b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, its balance sheet shows it holds CN¥220.6b in cash, so it actually has CN¥81.2b net cash.
A Look At Alibaba Group Holding's Liabilities
We can see from the most recent balance sheet that Alibaba Group Holding had liabilities of CN¥210.7b falling due within a year, and liabilities of CN¥170.2b due beyond that. Offsetting these obligations, it had cash of CN¥220.6b as well as receivables valued at CN¥29.9b due within 12 months. So its liabilities total CN¥130.3b more than the combination of its cash and short-term receivables.
Of course, Alibaba Group Holding has a titanic market capitalization of CN¥3.30t, 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. Despite its noteworthy liabilities, Alibaba Group Holding boasts net cash, so it's fair to say it does not have a heavy debt load!
Also positive, Alibaba Group Holding grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Alibaba Group Holding 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. Alibaba Group Holding may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Alibaba Group Holding 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.
We could understand if investors are concerned about Alibaba Group Holding's liabilities, but we can be reassured by the fact it has has net cash of CN¥81b. And it impressed us with free cash flow of CN¥91b, being 138% of its EBIT. So we don't think Alibaba Group Holding's use of debt is risky. Over time, share prices tend to follow earnings per share, so if you're interested in Alibaba Group Holding, you may well want to click here to check an interactive graph of its earnings per share history.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.