We Think Bodycote (LON:BOY) Can Stay On Top Of Its Debt

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Bodycote plc (LON:BOY) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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.

View our latest analysis for Bodycote

What Is Bodycote's Debt?

As you can see below, at the end of June 2021, Bodycote had UK£101.3m of debt, up from UK£47.5m a year ago. Click the image for more detail. On the flip side, it has UK£31.5m in cash leading to net debt of about UK£69.8m.

How Strong Is Bodycote's Balance Sheet?

We can see from the most recent balance sheet that Bodycote had liabilities of UK£281.0m falling due within a year, and liabilities of UK£124.4m due beyond that. On the other hand, it had cash of UK£31.5m and UK£134.3m worth of receivables due within a year. So its liabilities total UK£239.6m more than the combination of its cash and short-term receivables.

Given Bodycote has a market capitalization of UK£1.61b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

Bodycote has a low net debt to EBITDA ratio of only 0.47. And its EBIT covers its interest expense a whopping 21.1 times over. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Bodycote has seen its EBIT plunge 19% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Bodycote 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Bodycote recorded free cash flow worth a fulsome 96% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Bodycote's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that Bodycote can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. For example, we've discovered 2 warning signs for Bodycote that you should be aware of before investing here.

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.