Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Newell Brands Inc. (NASDAQ:NWL) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for Newell Brands
What Is Newell Brands’s Net Debt?
The image below, which you can click on for greater detail, shows that Newell Brands had debt of US$5.71b at the end of December 2019, a reduction from US$7.02b over a year. However, because it has a cash reserve of US$348.6m, its net debt is less, at about US$5.36b.
How Strong Is Newell Brands’s Balance Sheet?
We can see from the most recent balance sheet that Newell Brands had liabilities of US$2.98b falling due within a year, and liabilities of US$7.67b due beyond that. Offsetting these obligations, it had cash of US$348.6m as well as receivables valued at US$1.84b due within 12 months. So its liabilities total US$8.46b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company’s market capitalization of US$5.87b, we think shareholders really should watch Newell Brands’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). 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).
Newell Brands has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 2.7 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Even more troubling is the fact that Newell Brands actually let its EBIT decrease by 6.6% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill — a lot of effort for not much advancement. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Newell Brands 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 company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Newell Brands produced sturdy free cash flow equating to 63% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
Mulling over Newell Brands’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Overall, it seems to us that Newell Brands’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 4 warning signs for Newell Brands (1 shouldn’t be ignored!) that you should be aware of before investing here.
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.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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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