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. As with many other companies Allegro MicroSystems, Inc. (NASDAQ:ALGM) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Allegro MicroSystems's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Allegro MicroSystems had debt of US$245.1m, up from none in one year. However, it also had US$212.1m in cash, and so its net debt is US$33.0m.

How Strong Is Allegro MicroSystems' Balance Sheet?

According to the last reported balance sheet, Allegro MicroSystems had liabilities of US$117.9m due within 12 months, and liabilities of US$281.0m due beyond 12 months. Offsetting these obligations, it had cash of US$212.1m as well as receivables valued at US$125.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$61.6m.

This state of affairs indicates that Allegro MicroSystems' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the US$5.64b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, Allegro MicroSystems has a very light debt load indeed.

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.

Allegro MicroSystems's net debt is only 0.11 times its EBITDA. And its EBIT easily covers its interest expense, being 28.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Allegro MicroSystems has increased its EBIT by 7.4% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Allegro MicroSystems 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, Allegro MicroSystems's free cash flow amounted to 46% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Allegro MicroSystems's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. When we consider the range of factors above, it looks like Allegro MicroSystems is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Allegro MicroSystems insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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.

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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.

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