Is Kingspan Group (ISE:KRX) Using Too Much Debt?

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.' 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 Kingspan Group plc (ISE:KRX) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Kingspan Group

How Much Debt Does Kingspan Group Carry?

As you can see below, at the end of December 2022, Kingspan Group had €2.18b of debt, up from €1.40b a year ago. Click the image for more detail. However, it also had €649.3m in cash, and so its net debt is €1.53b.

How Healthy Is Kingspan Group's Balance Sheet?

According to the last reported balance sheet, Kingspan Group had liabilities of €1.80b due within 12 months, and liabilities of €2.49b due beyond 12 months. Offsetting this, it had €649.3m in cash and €1.27b in receivables that were due within 12 months. So its liabilities total €2.37b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Kingspan Group has a huge market capitalization of €11.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Kingspan Group's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its commanding EBIT of 21.5 times its interest expense, implies the debt load is as light as a peacock feather. Also good is that Kingspan Group grew its EBIT at 10% over the last year, further increasing its ability to manage debt. 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 Kingspan Group 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Kingspan Group recorded free cash flow worth 54% 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.

Our View

The good news is that Kingspan Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And its EBIT growth rate is good too. Looking at all the aforementioned factors together, it strikes us that Kingspan Group 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. For example - Kingspan Group has 3 warning signs we think you should be aware of.

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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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.