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.’ 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. Importantly, Patrick Industries, Inc. (NASDAQ:PATK) does carry debt. But the more important question is: how much risk is that debt creating?
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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Patrick Industries Carry?
As you can see below, Patrick Industries had US$586.5m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have US$23.6m in cash offsetting this, leading to net debt of about US$562.9m.
How Healthy Is Patrick Industries’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Patrick Industries had liabilities of US$205.1m due within 12 months and liabilities of US$667.2m due beyond that. Offsetting this, it had US$23.6m in cash and US$114.7m in receivables that were due within 12 months. So it has liabilities totalling US$734.0m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of US$1.05b, so it does suggest shareholders should keep an eye on Patrick Industries’s use of debt. This suggests shareholders would 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Patrick Industries’s debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 4.9 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. We saw Patrick Industries grow its EBIT by 3.6% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Patrick Industries 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Patrick Industries recorded free cash flow worth a fulsome 91% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
When it comes to the balance sheet, the standout positive for Patrick Industries was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren’t so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Patrick Industries’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. We’d be motivated to research the stock further if we found out that Patrick Industries insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
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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