Is Federal Signal (NYSE:FSS) A Risky Investment?

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 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. Importantly, Federal Signal Corporation (NYSE:FSS) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Federal Signal

How Much Debt Does Federal Signal Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 Federal Signal had US$361.3m of debt, an increase on US$281.4m, over one year. However, it also had US$47.5m in cash, and so its net debt is US$313.8m.

How Strong Is Federal Signal's Balance Sheet?

We can see from the most recent balance sheet that Federal Signal had liabilities of US$180.5m falling due within a year, and liabilities of US$482.9m due beyond that. Offsetting this, it had US$47.5m in cash and US$173.8m in receivables that were due within 12 months. So its liabilities total US$442.1m more than the combination of its cash and short-term receivables.

Since publicly traded Federal Signal shares are worth a total of US$3.29b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Federal Signal has a low net debt to EBITDA ratio of only 1.5. And its EBIT easily covers its interest expense, being 15.6 times the size. So we're pretty relaxed about its super-conservative use of debt. Also positive, Federal Signal grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Federal Signal's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Federal Signal's free cash flow amounted to 45% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Federal Signal's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Taking all this data into account, it seems to us that Federal Signal takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We'd be motivated to research the stock further if we found out that Federal Signal insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

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.