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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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies. Donaldson Company, Inc. (NYSE:DCI) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Donaldson Company Carry?
As you can see below, Donaldson Company had US$695.0m of debt, at April 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had US$203.8m in cash, and so its net debt is US$491.2m.
How Strong Is Donaldson Company’s Balance Sheet?
According to the last reported balance sheet, Donaldson Company had liabilities of US$446.4m due within 12 months, and liabilities of US$801.7m due beyond 12 months. Offsetting these obligations, it had cash of US$203.8m as well as receivables valued at US$546.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$497.7m.
Of course, Donaldson Company has a market capitalization of US$6.36b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Since Donaldson Company does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Donaldson Company has a low net debt to EBITDA ratio of only 1.04. And its EBIT easily covers its interest expense, being 19.4 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 Donaldson Company has increased its EBIT by 7.2% over twelve months, which should ease any concerns about debt repayment. 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 Donaldson Company 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Donaldson Company produced sturdy free cash flow equating to 55% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that Donaldson Company’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And we also thought its conversion of EBIT to free cash flow was a positive. Taking all this data into account, it seems to us that Donaldson Company takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Over time, share prices tend to follow earnings per share, so if you’re interested in Donaldson Company, you may well want to click here to check an interactive graph of its earnings per share history.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.