David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Modine Manufacturing Company (NYSE:MOD) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Modine Manufacturing's Debt?
The image below, which you can click on for greater detail, shows that Modine Manufacturing had debt of US$311.5m at the end of June 2021, a reduction from US$483.0m over a year. However, because it has a cash reserve of US$49.0m, its net debt is less, at about US$262.5m.
How Strong Is Modine Manufacturing's Balance Sheet?
We can see from the most recent balance sheet that Modine Manufacturing had liabilities of US$468.0m falling due within a year, and liabilities of US$491.7m due beyond that. Offsetting this, it had US$49.0m in cash and US$293.7m in receivables that were due within 12 months. So its liabilities total US$617.0m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$741.6m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Modine Manufacturing has net debt worth 1.6 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.6 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably, Modine Manufacturing's EBIT launched higher than Elon Musk, gaining a whopping 175% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Modine Manufacturing 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Modine Manufacturing produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On our analysis Modine Manufacturing's EBIT growth rate 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 instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the elements mentioned above, it seems to us that Modine Manufacturing is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 instance, we've identified 2 warning signs for Modine Manufacturing that you should be aware of.
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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