We Think Washington H. Soul Pattinson (ASX:SOL) Can Stay On Top Of Its Debt

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. We note that Washington H. Soul Pattinson and Company Limited (ASX:SOL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Washington H. Soul Pattinson

What Is Washington H. Soul Pattinson's Debt?

The image below, which you can click on for greater detail, shows that at January 2020 Washington H. Soul Pattinson had debt of AU$589.4m, up from AU$243.9m in one year. However, it does have AU$238.0m in cash offsetting this, leading to net debt of about AU$351.4m.

How Strong Is Washington H. Soul Pattinson's Balance Sheet?

According to the last reported balance sheet, Washington H. Soul Pattinson had liabilities of AU$469.7m due within 12 months, and liabilities of AU$1.22b due beyond 12 months. Offsetting these obligations, it had cash of AU$238.0m as well as receivables valued at AU$170.6m due within 12 months. So its liabilities total AU$1.28b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Washington H. Soul Pattinson has a market capitalization of AU$4.61b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Washington H. Soul Pattinson has net debt of just 0.85 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.1 times the interest expense over the last year. The modesty of its debt load may become crucial for Washington H. Soul Pattinson if management cannot prevent a repeat of the 52% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Washington H. Soul Pattinson'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.

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. During the last three years, Washington H. Soul Pattinson produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Washington H. Soul Pattinson's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we thought its net debt to EBITDA was a positive. Looking at all this data makes us feel a little cautious about Washington H. Soul Pattinson's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 3 warning signs we've spotted with Washington H. Soul Pattinson .

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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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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