Illinois Tool Works (NYSE:ITW) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Illinois Tool Works Inc. (NYSE:ITW) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Illinois Tool Works

How Much Debt Does Illinois Tool Works Carry?

The chart below, which you can click on for greater detail, shows that Illinois Tool Works had US$7.62b in debt in June 2019; about the same as the year before. On the flip side, it has US$1.68b in cash leading to net debt of about US$5.94b.

How Healthy Is Illinois Tool Works's Balance Sheet?

We can see from the most recent balance sheet that Illinois Tool Works had liabilities of US$2.19b falling due within a year, and liabilities of US$9.90b due beyond that. On the other hand, it had cash of US$1.68b and US$2.63b worth of receivables due within a year. So its liabilities total US$7.79b more than the combination of its cash and short-term receivables.

Since publicly traded Illinois Tool Works shares are worth a very impressive total of US$49.3b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Illinois Tool Works's net debt to EBITDA ratio of about 1.5 suggests only moderate use of debt. And its strong interest cover of 16.6 times, makes us even more comfortable. Unfortunately, Illinois Tool Works saw its EBIT slide 2.5% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Illinois Tool Works's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Illinois Tool Works produced sturdy free cash flow equating to 66% 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.

Our View

Happily, Illinois Tool Works's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its EBIT growth rate does undermine this impression a bit. All these things considered, it appears that Illinois Tool Works can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Over time, share prices tend to follow earnings per share, so if you're interested in Illinois Tool Works, 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.

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.

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. Thank you for reading.