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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Johnson Matthey Plc (LON:JMAT) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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. 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 examine debt levels, we first consider both cash and debt levels, together.
View our latest analysis for Johnson Matthey
What Is Johnson Matthey's Net Debt?
As you can see below, Johnson Matthey had UKĀ£1.20b of debt at March 2022, down from UKĀ£1.31b a year prior. However, it also had UKĀ£392.0m in cash, and so its net debt is UKĀ£811.0m.
How Healthy Is Johnson Matthey's Balance Sheet?
According to the last reported balance sheet, Johnson Matthey had liabilities of UKĀ£3.15b due within 12 months, and liabilities of UKĀ£1.07b due beyond 12 months. Offsetting these obligations, it had cash of UKĀ£392.0m as well as receivables valued at UKĀ£1.74b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UKĀ£2.09b.
This deficit is considerable relative to its market capitalization of UKĀ£3.33b, so it does suggest shareholders should keep an eye on Johnson Matthey's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Johnson Matthey's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 10.5 times the size. So we're pretty relaxed about its super-conservative use of debt. The good news is that Johnson Matthey has increased its EBIT by 7.7% over twelve months, which should ease any concerns about debt repayment. 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 Johnson Matthey's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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 45% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Our View
When it comes to the balance sheet, the standout positive for Johnson Matthey was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Johnson Matthey's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more 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. We've identified 3 warning signs with Johnson Matthey (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.
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.
About LSE:JMAT
Johnson Matthey
Engages in the clean air, catalyst and hydrogen technology, and platinum group metals (PGM) service businesses in the United Kingdom, Germany, rest of Europe, the United States, rest of North America, China, rest of Asia, and internationally.
Very undervalued with solid track record.
