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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. Importantly, Applied Industrial Technologies, Inc. (NYSE:AIT) does carry debt. But should shareholders be worried about its use of debt?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
How Much Debt Does Applied Industrial Technologies Carry?
As you can see below, Applied Industrial Technologies had US$981.7m of debt at March 2019, down from US$1.04b a year prior. On the flip side, it has US$47.4m in cash leading to net debt of about US$934.3m.
How Strong Is Applied Industrial Technologies’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Applied Industrial Technologies had liabilities of US$416.6m due within 12 months and liabilities of US$1.02b due beyond that. On the other hand, it had cash of US$47.4m and US$583.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$809.4m.
Applied Industrial Technologies has a market capitalization of US$2.27b, so it could very likely ameliorate its balance sheet if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Because it carries more debt than cash, we think it’s worth watching Applied Industrial Technologies’s balance sheet over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Applied Industrial Technologies has a debt to EBITDA ratio of 2.82 and its EBIT covered its interest expense 6.56 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Also relevant is that Applied Industrial Technologies has grown its EBIT by a very respectable 28% in the last year, thus enhancing its ability to pay down 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 Applied Industrial Technologies’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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Applied Industrial Technologies produced sturdy free cash flow equating to 62% 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.
Applied Industrial Technologies’s EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. All these things considered, it appears that Applied Industrial Technologies can comfortably handle its current debt levels. 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. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Applied Industrial Technologies insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.