Is Donaldson Company (NYSE:DCI) Using Too Much Debt?

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.' 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. As with many other companies Donaldson Company, Inc. (NYSE:DCI) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 Donaldson Company's Debt?

As you can see below, Donaldson Company had US$577.4m of debt at January 2025, down from US$614.1m a year prior. On the flip side, it has US$189.1m in cash leading to net debt of about US$388.3m.

How Healthy Is Donaldson Company's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Donaldson Company had liabilities of US$765.8m due within 12 months and liabilities of US$651.1m due beyond that. On the other hand, it had cash of US$189.1m and US$614.2m worth of receivables due within a year. So its liabilities total US$613.6m more than the combination of its cash and short-term receivables.

Of course, Donaldson Company has a market capitalization of US$8.11b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

See our latest analysis for Donaldson Company

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.

Donaldson Company has a low net debt to EBITDA ratio of only 0.59. And its EBIT easily covers its interest expense, being 25.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Donaldson Company grew its EBIT by 9.0% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Donaldson Company 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Donaldson Company recorded free cash flow worth 69% 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.

Our View

The good news is that Donaldson Company's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Looking at the bigger picture, we think Donaldson Company's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. We'd be motivated to research the stock further if we found out that Donaldson Company insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

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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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.