McMillan Shakespeare (ASX:MMS) Has A Pretty Healthy Balance Sheet

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that McMillan Shakespeare Limited (ASX:MMS) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for McMillan Shakespeare

What Is McMillan Shakespeare's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 McMillan Shakespeare had AU$278.6m of debt, an increase on AU$167.8m, over one year. However, it does have AU$60.6m in cash offsetting this, leading to net debt of about AU$218.0m.

A Look At McMillan Shakespeare's Liabilities

The latest balance sheet data shows that McMillan Shakespeare had liabilities of AU$550.7m due within a year, and liabilities of AU$353.3m falling due after that. Offsetting these obligations, it had cash of AU$60.6m as well as receivables valued at AU$40.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$803.4m.

While this might seem like a lot, it is not so bad since McMillan Shakespeare has a market capitalization of AU$1.53b, 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). 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).

McMillan Shakespeare's net debt is only 1.3 times its EBITDA. And its EBIT easily covers its interest expense, being 10.4 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, McMillan Shakespeare saw its EBIT drop by 8.5% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if McMillan Shakespeare 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, McMillan Shakespeare recorded free cash flow worth a fulsome 92% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Both McMillan Shakespeare's ability to to convert EBIT to free cash flow and its interest cover gave us comfort that it can handle its debt. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that McMillan Shakespeare is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For instance, we've identified 2 warning signs for McMillan Shakespeare that you should be aware of.

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.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.