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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Lincoln Electric Holdings, Inc. (NASDAQ:LECO) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Lincoln Electric Holdings Carry?
As you can see below, Lincoln Electric Holdings had US$765.5m of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$143.1m in cash, and so its net debt is US$622.4m.
How Healthy Is Lincoln Electric Holdings’s Balance Sheet?
According to the last reported balance sheet, Lincoln Electric Holdings had liabilities of US$568.6m due within 12 months, and liabilities of US$970.4m due beyond 12 months. Offsetting these obligations, it had cash of US$143.1m as well as receivables valued at US$373.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.02b.
Of course, Lincoln Electric Holdings has a market capitalization of US$5.54b, so these liabilities are probably manageable. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Lincoln Electric Holdings has a low net debt to EBITDA ratio of only 1.5. And its EBIT covers its interest expense a whopping 14.7 times over. So we’re pretty relaxed about its super-conservative use of debt. On the other hand, Lincoln Electric Holdings’s EBIT dived 14%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Lincoln Electric Holdings’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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Lincoln Electric Holdings recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Lincoln Electric Holdings’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that Lincoln Electric Holdings can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. Consider risks, for instance. Every company has them, and we’ve spotted 2 warning signs for Lincoln Electric Holdings you should know about.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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