Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Ultra Clean Holdings, Inc. (NASDAQ:UCTT) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Ultra Clean Holdings's Debt?

As you can see below, Ultra Clean Holdings had US$492.2m of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$318.2m in cash leading to net debt of about US$174.0m.

How Strong Is Ultra Clean Holdings' Balance Sheet?

The latest balance sheet data shows that Ultra Clean Holdings had liabilities of US$358.8m due within a year, and liabilities of US$666.3m falling due after that. Offsetting these obligations, it had cash of US$318.2m as well as receivables valued at US$228.1m due within 12 months. So it has liabilities totalling US$478.8m more than its cash and near-term receivables, combined.

Ultra Clean Holdings has a market capitalization of US$1.67b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Ultra Clean Holdings has a very low debt to EBITDA ratio of 1.2 so it is strange to see weak interest coverage, with last year's EBIT being only 1.7 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Notably Ultra Clean Holdings's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Ultra Clean Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Ultra Clean Holdings created free cash flow amounting to 9.0% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Ultra Clean Holdings's interest cover was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to handle its debt, based on its EBITDA, isn't too shabby at all. When we consider all the factors discussed, it seems to us that Ultra Clean Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Ultra Clean Holdings , and understanding them should be part of your investment process.

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.

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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.