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. We note that The Sherwin-Williams Company (NYSE:SHW) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Sherwin-Williams’s Debt?
As you can see below, Sherwin-Williams had US$8.69b of debt at December 2019, down from US$9.34b a year prior. And it doesn’t have much cash, so its net debt is about the same.
How Healthy Is Sherwin-Williams’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Sherwin-Williams had liabilities of US$4.54b due within 12 months and liabilities of US$11.9b due beyond that. Offsetting these obligations, it had cash of US$161.8m as well as receivables valued at US$2.09b due within 12 months. So its liabilities total US$14.1b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Sherwin-Williams is worth a massive US$52.6b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Sherwin-Williams has net debt to EBITDA of 2.9 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.7 suggests it can easily service that debt. Also relevant is that Sherwin-Williams has grown its EBIT by a very respectable 26% in the last year, thus enhancing its ability to pay down 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 Sherwin-Williams 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Sherwin-Williams generated free cash flow amounting to a very robust 83% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
Happily, Sherwin-Williams’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. Looking at the bigger picture, we think Sherwin-Williams’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Sherwin-Williams is showing 1 warning sign in our investment analysis , you should know about…
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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