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 can see that Netflix, Inc. (NASDAQ:NFLX) does use debt in its business. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Netflix
What Is Netflix's Debt?
As you can see below, Netflix had US$14.4b of debt, at March 2023, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$7.83b, its net debt is less, at about US$6.61b.
How Strong Is Netflix's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Netflix had liabilities of US$8.32b due within 12 months and liabilities of US$19.3b due beyond that. Offsetting this, it had US$7.83b in cash and US$1.03b in receivables that were due within 12 months. So it has liabilities totalling US$18.8b more than its cash and near-term receivables, combined.
Since publicly traded Netflix shares are worth a very impressive total of US$178.0b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Netflix has net debt of just 1.2 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 8.9 times, which is more than adequate. But the bad news is that Netflix has seen its EBIT plunge 13% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Netflix's ability to maintain a healthy balance sheet going forward. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Netflix recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Based on what we've seen Netflix is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that it has an adequate capacity to cover its interest expense with its EBIT. Looking at all this data makes us feel a little cautious about Netflix's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in Netflix, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
What are the risks and opportunities for Netflix?
Netflix, Inc. provides entertainment services.
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Rewards
Trading at 2.8% below our estimate of its fair value
Earnings are forecast to grow 18.16% per year
Risks
No risks detected for NFLX from our risks checks.
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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.
