Parker-Hannifin (NYSE:PH) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, Parker-Hannifin Corporation (NYSE:PH) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Parker-Hannifin

How Much Debt Does Parker-Hannifin Carry?

You can click the graphic below for the historical numbers, but it shows that Parker-Hannifin had US$10.5b of debt in June 2024, down from US$12.5b, one year before. However, it also had US$422.0m in cash, and so its net debt is US$10.0b.

How Healthy Is Parker-Hannifin's Balance Sheet?

We can see from the most recent balance sheet that Parker-Hannifin had liabilities of US$7.31b falling due within a year, and liabilities of US$9.90b due beyond that. Offsetting these obligations, it had cash of US$422.0m as well as receivables valued at US$3.33b due within 12 months. So its liabilities total US$13.5b more than the combination of its cash and short-term receivables.

Since publicly traded Parker-Hannifin shares are worth a very impressive total of US$81.4b, 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.

Parker-Hannifin's net debt of 2.0 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.1 times interest expense) certainly does not do anything to dispel this impression. One way Parker-Hannifin could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Parker-Hannifin 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Parker-Hannifin 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

Parker-Hannifin'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. And its EBIT growth rate is good too. When we consider the range of factors above, it looks like Parker-Hannifin is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Parker-Hannifin you should know about.

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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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.