David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Experian plc (LON:EXPN) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Experian's Debt?
As you can see below, Experian had US$4.08b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$169.0m in cash leading to net debt of about US$3.91b.
How Strong Is Experian's Balance Sheet?
We can see from the most recent balance sheet that Experian had liabilities of US$1.80b falling due within a year, and liabilities of US$4.74b due beyond that. Offsetting these obligations, it had cash of US$169.0m as well as receivables valued at US$1.09b due within 12 months. So its liabilities total US$5.29b more than the combination of its cash and short-term receivables.
Given Experian has a humongous market capitalization of US$35.2b, 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.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Experian has net debt to EBITDA of 2.5 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 9.8 times its interest expense, and its net debt to EBITDA, was quite high, at 2.5. Importantly Experian's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Experian's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Experian produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Experian's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. Looking at all the aforementioned factors together, it strikes us that Experian 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Experian , and understanding them should be part of your investment process.
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.
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