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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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies. Kingspan Group plc (ISE:KRX) makes use of debt. But the more important question is: how much risk is that debt creating?
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 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Kingspan Group’s Debt?
The image below, which you can click on for greater detail, shows that at December 2018 Kingspan Group had debt of €1.02b, up from €662.7m in one year. On the flip side, it has €294.5m in cash leading to net debt of about €725.7m.
How Healthy Is Kingspan Group’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Kingspan Group had liabilities of €1.02b due within 12 months and liabilities of €1.22b due beyond that. Offsetting these obligations, it had cash of €294.5m as well as receivables valued at €767.2m due within 12 months. So it has liabilities totalling €1.18b more than its cash and near-term receivables, combined.
Given Kingspan Group has a market capitalization of €8.48b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. Since Kingspan Group does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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).
Kingspan Group’s net debt is only 1.38 times its EBITDA. And its EBIT easily covers its interest expense, being 23.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Kingspan Group grew its EBIT by 17% last year, making its debt load easier to handle. 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’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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Kingspan Group recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Kingspan Group’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 the good news does not stop there, as its EBIT growth rate also supports that impression! Taking all this data into account, it seems to us that Kingspan Group takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Kingspan Group insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.