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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.’ 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, Dover Corporation (NYSE:DOV) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Dover’s Net Debt?
As you can see below, Dover had US$3.30b of debt at March 2019, down from US$3.46b a year prior. However, it does have US$243.0m in cash offsetting this, leading to net debt of about US$3.05b.
How Healthy Is Dover’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Dover had liabilities of US$1.95b due within 12 months and liabilities of US$3.87b due beyond that. Offsetting this, it had US$243.0m in cash and US$1.27b in receivables that were due within 12 months. So its liabilities total US$4.31b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Dover is worth a massive US$15.0b, and thus could probably raise enough capital to shore up 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. Either way, since Dover does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Dover’s net debt of 2.47 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.98 times its interest expenses harmonizes with that theme. Dover grew its EBIT by 7.9% in the last year. That’s far from incredible but it is a good thing, when it comes to paying off debt. 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 Dover’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.
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. During the last three years, Dover produced sturdy free cash flow equating to 73% 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.
Dover’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. All these things considered, it appears that Dover 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 Dover insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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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.