ESCO Technologies (NYSE:ESE) Seems To Use Debt Quite Sensibly

By
Simply Wall St
Published
November 29, 2021
NYSE:ESE
Source: Shutterstock

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.' 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. We can see that ESCO Technologies Inc. (NYSE:ESE) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for ESCO Technologies

What Is ESCO Technologies's Debt?

The image below, which you can click on for greater detail, shows that at September 2021 ESCO Technologies had debt of US$154.0m, up from US$62.4m in one year. However, because it has a cash reserve of US$56.2m, its net debt is less, at about US$97.8m.

debt-equity-history-analysis
NYSE:ESE Debt to Equity History November 30th 2021

How Healthy Is ESCO Technologies' Balance Sheet?

The latest balance sheet data shows that ESCO Technologies had liabilities of US$277.8m due within a year, and liabilities of US$279.9m falling due after that. Offsetting these obligations, it had cash of US$56.2m as well as receivables valued at US$240.1m due within 12 months. So it has liabilities totalling US$261.3m more than its cash and near-term receivables, combined.

Of course, ESCO Technologies has a market capitalization of US$2.22b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

ESCO Technologies has a low net debt to EBITDA ratio of only 0.76. And its EBIT easily covers its interest expense, being 38.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that ESCO Technologies saw its EBIT decline by 8.6% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 ESCO Technologies'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, ESCO Technologies recorded free cash flow worth 70% 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.

Our View

The good news is that ESCO Technologies's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that ESCO Technologies can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Over time, share prices tend to follow earnings per share, so if you're interested in ESCO Technologies, you may well want to click here to check an interactive graph of its earnings per share history.

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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