These 4 Measures Indicate That Melrose Industries (LON:MRO) Is Using Debt Extensively

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.' 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 is this debt a concern to shareholders?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Melrose Industries

How Much Debt Does Melrose Industries Carry?

As you can see below, Melrose Industries had UK£665.0m of debt at June 2023, down from UK£1.53b a year prior. However, because it has a cash reserve of UK£110.0m, its net debt is less, at about UK£555.0m.

How Healthy Is Melrose Industries' Balance Sheet?

According to the last reported balance sheet, Melrose Industries had liabilities of UK£1.66b due within 12 months, and liabilities of UK£1.76b due beyond 12 months. On the other hand, it had cash of UK£110.0m and UK£797.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£2.51b.

This deficit isn't so bad because Melrose Industries is worth UK£6.16b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Melrose Industries has a very low debt to EBITDA ratio of 0.61 so it is strange to see weak interest coverage, with last year's EBIT being only 1.7 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that Melrose Industries improved its EBIT from a last year's loss to a positive UK£137m. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Melrose Industries can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Melrose Industries burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Melrose Industries's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Melrose Industries stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. For example - Melrose Industries has 1 warning sign we think you should be aware of.

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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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.