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. Importantly, Fortune Brands Home & Security, Inc. (NYSE:FBHS) does carry debt. But is this debt a concern to shareholders?
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. 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.
What Is Fortune Brands Home & Security’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Fortune Brands Home & Security had debt of US$2.35b, up from US$2.5k in one year. However, it does have US$336.2m in cash offsetting this, leading to net debt of about US$2.01b.
A Look At Fortune Brands Home & Security’s Liabilities
According to the last reported balance sheet, Fortune Brands Home & Security had liabilities of US$1.38b due within 12 months, and liabilities of US$2.57b due beyond 12 months. Offsetting these obligations, it had cash of US$336.2m as well as receivables valued at US$640.1m due within 12 months. So its liabilities total US$2.97b more than the combination of its cash and short-term receivables.
Fortune Brands Home & Security has a market capitalization of US$9.73b, so it could very likely raise cash to ameliorate 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Fortune Brands Home & Security’s net debt of 2.3 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.8 times interest expense) certainly does not do anything to dispel this impression. Fortune Brands Home & Security grew its EBIT by 6.4% in the last year. That’s far from incredible but it is a good thing, when it comes to paying off debt. 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 Fortune Brands Home & Security can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept 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, Fortune Brands Home & Security produced sturdy free cash flow equating to 65% 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.
Fortune Brands Home & Security’s conversion of EBIT to free cash flow was a real positive on this analysis, as was its interest cover. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Fortune Brands Home & Security is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 1 warning sign for Fortune Brands Home & Security that you should be aware of before investing here.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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.
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