Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that Diodes Incorporated (NASDAQ:DIOD) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Diodes's Net Debt?
The image below, which you can click on for greater detail, shows that Diodes had debt of US$46.7m at the end of June 2024, a reduction from US$89.5m over a year. But it also has US$273.9m in cash to offset that, meaning it has US$227.2m net cash.
How Healthy Is Diodes' Balance Sheet?
According to the last reported balance sheet, Diodes had liabilities of US$361.0m due within 12 months, and liabilities of US$148.5m due beyond 12 months. Offsetting this, it had US$273.9m in cash and US$385.0m in receivables that were due within 12 months. So it actually has US$149.4m more liquid assets than total liabilities.
This surplus suggests that Diodes has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Diodes boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that Diodes's load is not too heavy, because its EBIT was down 75% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Diodes 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. Diodes 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. Looking at the most recent three years, Diodes recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Summing Up
While it is always sensible to investigate a company's debt, in this case Diodes has US$227.2m in net cash and a decent-looking balance sheet. So we are not troubled with Diodes's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Diodes has 2 warning signs we think you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
