Here’s Why Johnson Matthey (LON:JMAT) Can Manage Its Debt Responsibly

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. We note that Johnson Matthey Plc (LON:JMAT) does have debt on its balance sheet. 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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for Johnson Matthey

What Is Johnson Matthey’s Debt?

As you can see below, at the end of March 2019, Johnson Matthey had UK£1.32b of debt, up from UK£1.06b a year ago. Click the image for more detail. However, it also had UK£459.0m in cash, and so its net debt is UK£857.0m.

LSE:JMAT Historical Debt, August 18th 2019
LSE:JMAT Historical Debt, August 18th 2019

How Healthy Is Johnson Matthey’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Johnson Matthey had liabilities of UK£2.05b due within 12 months and liabilities of UK£1.28b due beyond that. On the other hand, it had cash of UK£459.0m and UK£1.48b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£1.40b.

While this might seem like a lot, it is not so bad since Johnson Matthey has a market capitalization of UK£5.37b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Johnson Matthey’s net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 12.3 times over. So we’re pretty relaxed about its super-conservative use of debt. The good news is that Johnson Matthey has increased its EBIT by 9.9% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Johnson Matthey 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. Looking at the most recent three years, Johnson Matthey 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.

Our View

On our analysis Johnson Matthey’s interest cover should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Considering this range of data points, we think Johnson Matthey is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Johnson Matthey’s dividend history, without delay!

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.