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. Importantly, Deere & Company (NYSE:DE) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Deere Carry?
As you can see below, Deere had US$46.0b of debt, at November 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$6.83b, its net debt is less, at about US$39.2b.
A Look At Deere's Liabilities
Zooming in on the latest balance sheet data, we can see that Deere had liabilities of US$23.2b due within 12 months and liabilities of US$39.0b due beyond that. On the other hand, it had cash of US$6.83b and US$5.55b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$49.8b.
Deere has a very large market capitalization of US$95.2b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
As it happens Deere has a fairly concerning net debt to EBITDA ratio of 7.2 but very strong interest coverage of 16.3. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Deere grew its EBIT by 5.5% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Deere's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Deere recorded free cash flow of 28% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Neither Deere's ability handle its debt, based on its EBITDA, nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. We think that Deere'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. 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. To that end, you should learn about the 2 warning signs we've spotted with Deere (including 1 which doesn't sit too well with us) .
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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