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.' 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 ESCO Technologies Inc. (NYSE:ESE) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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. 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.
How Much Debt Does ESCO Technologies Carry?
You can click the graphic below for the historical numbers, but it shows that ESCO Technologies had US$22.0m of debt in March 2021, down from US$152.0m, one year before. However, its balance sheet shows it holds US$45.7m in cash, so it actually has US$23.7m net cash.
A Look At ESCO Technologies' Liabilities
According to the last reported balance sheet, ESCO Technologies had liabilities of US$246.6m due within 12 months, and liabilities of US$115.8m due beyond 12 months. Offsetting this, it had US$45.7m in cash and US$219.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$97.2m.
Since publicly traded ESCO Technologies shares are worth a total of US$2.50b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, ESCO Technologies boasts net cash, so it's fair to say it does not have a heavy debt load!
But the bad news is that ESCO Technologies has seen its EBIT plunge 10% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ESCO Technologies can strengthen its balance sheet over time. 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. ESCO Technologies may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, ESCO Technologies produced sturdy free cash flow equating to 65% 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.
We could understand if investors are concerned about ESCO Technologies's liabilities, but we can be reassured by the fact it has has net cash of US$23.7m. So we don't have any problem with ESCO Technologies's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - ESCO Technologies has 3 warning signs we think you should be aware of.
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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