Is James Hardie Industries (ASX:JHX) A Risky Investment?

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. Importantly, James Hardie Industries plc (ASX:JHX) does carry debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 James Hardie Industries

What Is James Hardie Industries's Net Debt?

The image below, which you can click on for greater detail, shows that James Hardie Industries had debt of US$1.25b at the end of September 2020, a reduction from US$1.43b over a year. However, because it has a cash reserve of US$390.6m, its net debt is less, at about US$864.2m.

How Strong Is James Hardie Industries' Balance Sheet?

The latest balance sheet data shows that James Hardie Industries had liabilities of US$545.2m due within a year, and liabilities of US$2.47b falling due after that. Offsetting these obligations, it had cash of US$390.6m as well as receivables valued at US$311.2m due within 12 months. So its liabilities total US$2.32b more than the combination of its cash and short-term receivables.

Of course, James Hardie Industries has a titanic market capitalization of US$12.7b, 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.

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.

With net debt sitting at just 1.3 times EBITDA, James Hardie Industries is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 10.0 times the interest expense over the last year. Also positive, James Hardie Industries grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. 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 James Hardie Industries'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.

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. In the last three years, James Hardie Industries's free cash flow amounted to 45% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, James Hardie Industries's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at all the aforementioned factors together, it strikes us that James Hardie Industries 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with James Hardie Industries , and understanding them should be part of your investment process.

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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