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.' 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 Fortune Brands Home & Security, Inc. (NYSE:FBHS) makes use of debt. But the more important question is: how much risk is that debt creating?
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. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Fortune Brands Home & Security Carry?
As you can see below, at the end of June 2022, Fortune Brands Home & Security had US$3.36b of debt, up from US$2.61b a year ago. Click the image for more detail. However, it does have US$360.6m in cash offsetting this, leading to net debt of about US$3.00b.
How Strong Is Fortune Brands Home & Security's Balance Sheet?
We can see from the most recent balance sheet that Fortune Brands Home & Security had liabilities of US$1.44b falling due within a year, and liabilities of US$3.94b due beyond that. Offsetting this, it had US$360.6m in cash and US$998.5m in receivables that were due within 12 months. So its liabilities total US$4.02b more than the combination of its cash and short-term receivables.
Fortune Brands Home & Security has a market capitalization of US$6.94b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). 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).
Fortune Brands Home & Security's net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its strong interest cover of 12.0 times, makes us even more comfortable. We saw Fortune Brands Home & Security grow its EBIT by 8.6% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Fortune Brands Home & Security'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 always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Fortune Brands Home & Security recorded free cash flow worth 52% 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.
When it comes to the balance sheet, the standout positive for Fortune Brands Home & Security was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Fortune Brands Home & Security is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Fortune Brands Home & Security (including 1 which is a bit unpleasant) .
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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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.
Fortune Brands Home & Security
Fortune Brands Home & Security, Inc. provides home and security products for residential home repair, remodeling, new construction, and security applications.
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Undervalued established dividend payer.