Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Marshalls plc (LON:MSLH) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Marshalls Carry?
You can click the graphic below for the historical numbers, but it shows that Marshalls had UK£60.5m of debt in June 2021, down from UK£139.9m, one year before. However, because it has a cash reserve of UK£52.3m, its net debt is less, at about UK£8.20m.
How Strong Is Marshalls' Balance Sheet?
We can see from the most recent balance sheet that Marshalls had liabilities of UK£175.6m falling due within a year, and liabilities of UK£99.9m due beyond that. Offsetting these obligations, it had cash of UK£52.3m as well as receivables valued at UK£119.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£104.3m.
Of course, Marshalls has a market capitalization of UK£1.54b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Marshalls has virtually no net debt, so it's fair to say it does not have a heavy debt load!
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Marshalls's net debt is only 0.10 times its EBITDA. And its EBIT easily covers its interest expense, being 13.4 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Marshalls grew its EBIT by 63% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Marshalls'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Marshalls recorded free cash flow worth 71% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Marshalls's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Considering this range of factors, it seems to us that Marshalls is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. We'd be very excited to see if Marshalls insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.
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