David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. 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 American Woodmark Corporation (NASDAQ:AMWD) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is American Woodmark’s Debt?
As you can see below, American Woodmark had US$614.2m of debt at October 2019, down from US$722.4m a year prior. On the flip side, it has US$51.4m in cash leading to net debt of about US$562.7m.
How Healthy Is American Woodmark’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that American Woodmark had liabilities of US$169.4m due within 12 months and liabilities of US$754.3m due beyond that. Offsetting this, it had US$51.4m in cash and US$122.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$749.5m.
This deficit isn’t so bad because American Woodmark is worth US$1.95b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
American Woodmark has net debt worth 2.4 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 4.5 times the interest expense. While that doesn’t worry us too much, it does suggest the interest payments are somewhat of a burden. American Woodmark grew its EBIT by 2.4% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if American Woodmark 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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, American Woodmark produced sturdy free cash flow equating to 73% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
On our analysis American Woodmark’s conversion of EBIT to free cash flow should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. Considering this range of data points, we think American Woodmark is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Consider for instance, the ever-present spectre of investment risk. We’ve identified 1 warning sign with American Woodmark , and understanding them should be part of your investment process.
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.
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