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Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that James Hardie Industries plc (ASX:JHX) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does James Hardie Industries Carry?
As you can see below, at the end of March 2019, James Hardie Industries had US$1.38b of debt, up from US$884.4m a year ago. Click the image for more detail. However, it also had US$78.7m in cash, and so its net debt is US$1.30b.
How Strong Is James Hardie Industries’s Balance Sheet?
According to the last reported balance sheet, James Hardie Industries had liabilities of US$483.0m due within 12 months, and liabilities of US$2.58b due beyond 12 months. Offsetting this, it had US$78.7m in cash and US$262.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.72b.
While this might seem like a lot, it is not so bad since James Hardie Industries has a market capitalization of US$5.75b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Because it carries more debt than cash, we think it’s worth watching James Hardie Industries’s balance sheet 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.
James Hardie Industries’s net debt of 2.41 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.43 times interest expense) certainly does not do anything to dispel this impression. We saw James Hardie Industries grow its EBIT by 6.3% in the last twelve months. That’s far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, James Hardie Industries recorded free cash flow of 30% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Neither James Hardie Industries’s ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But we do take some comfort from its interest cover. Looking at all the angles mentioned above, it does seem to us that James Hardie Industries is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of James Hardie Industries’s earnings per share history for free.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.