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 Verisk Analytics, Inc. (NASDAQ:VRSK) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Verisk Analytics Carry?
The image below, which you can click on for greater detail, shows that at March 2020 Verisk Analytics had debt of US$3.09b, up from US$2.60b in one year. However, because it has a cash reserve of US$207.4m, its net debt is less, at about US$2.88b.
How Healthy Is Verisk Analytics’s Balance Sheet?
We can see from the most recent balance sheet that Verisk Analytics had liabilities of US$1.60b falling due within a year, and liabilities of US$3.25b due beyond that. Offsetting these obligations, it had cash of US$207.4m as well as receivables valued at US$523.3m due within 12 months. So it has liabilities totalling US$4.1b more than its cash and near-term receivables, combined.
Of course, Verisk Analytics has a titanic market capitalization of US$28.3b, so these liabilities are probably manageable. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
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).
Verisk Analytics has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 6.7 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Verisk Analytics grew its EBIT by 2.2% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Verisk Analytics’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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Verisk Analytics generated free cash flow amounting to a very robust 80% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Happily, Verisk Analytics’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Verisk Analytics 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. 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. To that end, you should be aware of the 1 warning sign we’ve spotted with Verisk Analytics .
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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