Ferguson (NYSE:FERG) Seems To Use Debt Quite Sensibly

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Ferguson plc (NYSE:FERG) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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.

Check out our latest analysis for Ferguson

What Is Ferguson's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of April 2023 Ferguson had US$3.93b of debt, an increase on US$3.52b, over one year. However, it also had US$625.0m in cash, and so its net debt is US$3.30b.

A Look At Ferguson's Liabilities

We can see from the most recent balance sheet that Ferguson had liabilities of US$5.13b falling due within a year, and liabilities of US$5.52b due beyond that. On the other hand, it had cash of US$625.0m and US$3.38b worth of receivables due within a year. So its liabilities total US$6.64b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Ferguson has a huge market capitalization of US$29.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Ferguson has a low net debt to EBITDA ratio of only 1.0. And its EBIT easily covers its interest expense, being 16.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Ferguson grew its EBIT by 6.3% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Ferguson can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Ferguson recorded free cash flow worth 59% 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.

Our View

Happily, Ferguson's impressive interest cover implies it has the upper hand on its debt. And we also thought its net debt to EBITDA was a positive. When we consider the range of factors above, it looks like Ferguson is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Ferguson , and understanding them should be part of your investment process.

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.