Is Melrose Industries (LON:MRO) Using Debt In A Risky Way?

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. As with many other companies Melrose Industries PLC (LON:MRO) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Melrose Industries

What Is Melrose Industries's Debt?

As you can see below, Melrose Industries had UK£1.37b of debt at December 2021, down from UK£3.26b a year prior. However, because it has a cash reserve of UK£473.0m, its net debt is less, at about UK£892.0m.

A Look At Melrose Industries' Liabilities

According to the last reported balance sheet, Melrose Industries had liabilities of UK£3.12b due within 12 months, and liabilities of UK£3.36b due beyond 12 months. Offsetting this, it had UK£473.0m in cash and UK£1.20b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£4.81b.

This deficit is considerable relative to its market capitalization of UK£5.44b, so it does suggest shareholders should keep an eye on Melrose Industries' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Melrose Industries 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.

In the last year Melrose Industries had a loss before interest and tax, and actually shrunk its revenue by 22%, to UK£6.9b. To be frank that doesn't bode well.

Caveat Emptor

While Melrose Industries's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. To be specific the EBIT loss came in at UK£497m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. For example, we would not want to see a repeat of last year's loss of UK£450m. So we do think this stock is quite 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 1 warning sign we've spotted with Melrose Industries .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.