Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Ribbon Communications Inc. (NASDAQ:RBBN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Ribbon Communications Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Ribbon Communications had debt of US$337.5m, up from US$292.0m in one year. On the flip side, it has US$64.6m in cash leading to net debt of about US$272.9m.

How Healthy Is Ribbon Communications' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ribbon Communications had liabilities of US$272.6m due within 12 months and liabilities of US$427.9m due beyond that. Offsetting this, it had US$64.6m in cash and US$211.0m in receivables that were due within 12 months. So its liabilities total US$424.9m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of US$558.5m, so it does suggest shareholders should keep an eye on Ribbon Communications' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

While Ribbon Communications's debt to EBITDA ratio (3.3) suggests that it uses some debt, its interest cover is very weak, at 0.46, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. One redeeming factor for Ribbon Communications is that it turned last year's EBIT loss into a gain of US$14m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Ribbon Communications'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. In the last year, Ribbon Communications created free cash flow amounting to 4.0% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We'd go so far as to say Ribbon Communications's interest cover was disappointing. Having said that, its ability to grow its EBIT isn't such a worry. Overall, it seems to us that Ribbon Communications's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Ribbon Communications that you should be aware of.

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.

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.