Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that ITT Inc. (NYSE:ITT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is ITT's Net Debt?
As you can see below, ITT had US$132.2m of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. But it also has US$782.3m in cash to offset that, meaning it has US$650.1m net cash.
How Healthy Is ITT's Balance Sheet?
According to the last reported balance sheet, ITT had liabilities of US$866.0m due within 12 months, and liabilities of US$1.29b due beyond 12 months. Offsetting this, it had US$782.3m in cash and US$507.6m in receivables that were due within 12 months. So its liabilities total US$862.0m more than the combination of its cash and short-term receivables.
Given ITT has a market capitalization of US$6.60b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, ITT also has more cash than debt, so we're pretty confident it can manage its debt safely.
But the bad news is that ITT has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 ITT 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. While ITT has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, ITT recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although ITT's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$650.1m. The cherry on top was that in converted 79% of that EBIT to free cash flow, bringing in US$384m. So we don't have any problem with ITT's use of debt. 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. For example, we've discovered 2 warning signs for ITT that you should be aware of before investing here.
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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