The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Sensata Technologies Holding plc (NYSE:ST) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Sensata Technologies Holding’s Debt?
The chart below, which you can click on for greater detail, shows that Sensata Technologies Holding had US$3.22b in debt in December 2019; about the same as the year before. However, it does have US$774.1m in cash offsetting this, leading to net debt of about US$2.45b.
A Look At Sensata Technologies Holding’s Liabilities
We can see from the most recent balance sheet that Sensata Technologies Holding had liabilities of US$634.7m falling due within a year, and liabilities of US$3.63b due beyond that. Offsetting this, it had US$774.1m in cash and US$557.9m in receivables that were due within 12 months. So its liabilities total US$2.93b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$4.33b. 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).
Sensata Technologies Holding has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 3.8 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 Sensata Technologies Holding actually let its EBIT decrease by 8.7% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Sensata Technologies Holding’s ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Sensata Technologies Holding recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Sensata Technologies Holding’s EBIT growth rate and interest cover definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Sensata Technologies Holding’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We’ve spotted 3 warning signs for Sensata Technologies Holding you should be aware of, and 1 of them shouldn’t be ignored.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.