Is MSC Industrial Direct (NYSE:MSM) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that MSC Industrial Direct Co., Inc. (NYSE:MSM) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for MSC Industrial Direct

How Much Debt Does MSC Industrial Direct Carry?

The image below, which you can click on for greater detail, shows that at November 2019 MSC Industrial Direct had debt of US$402.0m, up from US$523 in one year. However, it also had US$27.8m in cash, and so its net debt is US$374.2m.

How Strong Is MSC Industrial Direct's Balance Sheet?

According to the last reported balance sheet, MSC Industrial Direct had liabilities of US$403.8m due within 12 months, and liabilities of US$419.6m due beyond 12 months. Offsetting this, it had US$27.8m in cash and US$536.9m in receivables that were due within 12 months. So it has liabilities totalling US$258.7m more than its cash and near-term receivables, combined.

Since publicly traded MSC Industrial Direct shares are worth a total of US$3.95b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

MSC Industrial Direct's net debt is only 0.77 times its EBITDA. And its EBIT covers its interest expense a whopping 26.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that MSC Industrial Direct saw its EBIT decline by 7.4% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine MSC Industrial Direct'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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, MSC Industrial Direct produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, MSC Industrial Direct'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. Looking at all the aforementioned factors together, it strikes us that MSC Industrial Direct can handle its debt fairly comfortably. 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. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check MSC Industrial Direct's dividend history, without delay!

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 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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