Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 can see that Armstrong World Industries, Inc. (NYSE:AWI) does use debt in its business. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Armstrong World Industries's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Armstrong World Industries had debt of US$744.4m, up from US$626.4m in one year. However, it also had US$136.9m in cash, and so its net debt is US$607.5m.
How Healthy Is Armstrong World Industries' Balance Sheet?
We can see from the most recent balance sheet that Armstrong World Industries had liabilities of US$172.3m falling due within a year, and liabilities of US$1.10b due beyond that. Offsetting these obligations, it had cash of US$136.9m as well as receivables valued at US$80.6m due within 12 months. So its liabilities total US$1.05b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Armstrong World Industries has a market capitalization of US$4.46b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Armstrong World Industries's net debt of 2.3 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.5 times interest expense) certainly does not do anything to dispel this impression. Shareholders should be aware that Armstrong World Industries's EBIT was down 31% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Armstrong World Industries'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. Over the most recent three years, Armstrong World Industries recorded free cash flow worth 62% 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.
Armstrong World Industries's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its conversion of EBIT to free cash flow is relatively strong. We think that Armstrong World Industries's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 1 warning sign for Armstrong World Industries that you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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