Is MSC Industrial Direct (NYSE:MSM) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, MSC Industrial Direct Co., Inc. (NYSE:MSM) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for MSC Industrial Direct

What Is MSC Industrial Direct's Net Debt?

The chart below, which you can click on for greater detail, shows that MSC Industrial Direct had US$681.3m in debt in February 2021; about the same as the year before. However, it also had US$20.2m in cash, and so its net debt is US$661.1m.

How Healthy Is MSC Industrial Direct's Balance Sheet?

The latest balance sheet data shows that MSC Industrial Direct had liabilities of US$553.2m due within a year, and liabilities of US$630.5m falling due after that. On the other hand, it had cash of US$20.2m and US$527.2m worth of receivables due within a year. So it has liabilities totalling US$636.2m more than its cash and near-term receivables, combined.

Of course, MSC Industrial Direct has a market capitalization of US$5.03b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

We'd say that MSC Industrial Direct's moderate net debt to EBITDA ratio ( being 1.5), indicates prudence when it comes to debt. And its strong interest cover of 21.6 times, makes us even more comfortable. But the bad news is that MSC Industrial Direct has seen its EBIT plunge 11% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if MSC Industrial Direct 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, MSC Industrial Direct produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that MSC Industrial Direct's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its EBIT growth rate has the opposite effect. All these things considered, it appears that MSC Industrial Direct can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for MSC Industrial Direct you should know about.

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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