Warren Buffett famously said, '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 Allegion plc (NYSE:ALLE) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.
What Is Allegion's Net Debt?
As you can see below, Allegion had US$1.43b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$503.9m in cash offsetting this, leading to net debt of about US$927.0m.
How Healthy Is Allegion's Balance Sheet?
We can see from the most recent balance sheet that Allegion had liabilities of US$793.9m falling due within a year, and liabilities of US$1.46b due beyond that. Offsetting this, it had US$503.9m in cash and US$307.4m in receivables that were due within 12 months. So its liabilities total US$1.44b more than the combination of its cash and short-term receivables.
Since publicly traded Allegion shares are worth a very impressive total of US$11.0b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Allegion has a low net debt to EBITDA ratio of only 1.4. And its EBIT easily covers its interest expense, being 12.5 times the size. So we're pretty relaxed about its super-conservative use of debt. Also good is that Allegion grew its EBIT at 13% 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 Allegion 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Allegion produced sturdy free cash flow equating to 80% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Allegion'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 conversion of EBIT to free cash flow is also very heartening. Zooming out, Allegion seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Allegion that 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.
What are the risks and opportunities for Allegion?
Earnings are forecast to grow 10.73% per year
Debt is not well covered by operating cash flow
Significant insider selling over the past 3 months
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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.