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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.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Hillenbrand, Inc. (NYSE:HI) 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 and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Hillenbrand Carry?
The image below, which you can click on for greater detail, shows that Hillenbrand had debt of US$363.4m at the end of March 2019, a reduction from US$479.1m over a year. However, it does have US$58.6m in cash offsetting this, leading to net debt of about US$304.8m.
How Strong Is Hillenbrand’s Balance Sheet?
According to the last reported balance sheet, Hillenbrand had liabilities of US$505.8m due within 12 months, and liabilities of US$609.6m due beyond 12 months. Offsetting these obligations, it had cash of US$58.6m as well as receivables valued at US$364.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$692.5m.
While this might seem like a lot, it is not so bad since Hillenbrand has a market capitalization of US$2.48b, 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. Either way, since Hillenbrand does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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). 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).
Hillenbrand’s net debt is only 1.04 times its EBITDA. And its EBIT easily covers its interest expense, being 10.7 times the size. So we’re pretty relaxed about its super-conservative use of debt. But the other side of the story is that Hillenbrand saw its EBIT decline by 3.6% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hillenbrand 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hillenbrand generated free cash flow amounting to a very robust 90% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Hillenbrand’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. 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 Hillenbrand 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 Hillenbrand, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.