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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. As with many other companies. Parker-Hannifin Corporation (NYSE:PH) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Parker-Hannifin Carry?
As you can see below, Parker-Hannifin had US$5.30b of debt at March 2019, down from US$5.87b a year prior. However, because it has a cash reserve of US$1.17b, its net debt is less, at about US$4.13b.
How Strong Is Parker-Hannifin’s Balance Sheet?
According to the last reported balance sheet, Parker-Hannifin had liabilities of US$3.55b due within 12 months, and liabilities of US$5.91b due beyond 12 months. Offsetting this, it had US$1.17b in cash and US$2.46b in receivables that were due within 12 months. So its liabilities total US$5.83b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Parker-Hannifin has a huge market capitalization of US$21.7b, 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 Parker-Hannifin does have more debt than cash, it’s worth keeping an eye on its balance sheet.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
We’d say that Parker-Hannifin’s moderate net debt to EBITDA ratio ( being 1.62), indicates prudence when it comes to debt. And its commanding EBIT of 10.9 times its interest expense, implies the debt load is as light as a peacock feather. If Parker-Hannifin can keep growing EBIT at last year’s rate of 14% over the last year, then it will find its debt load easier to manage. 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 Parker-Hannifin 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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Parker-Hannifin recorded free cash flow worth 73% 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.
Happily, Parker-Hannifin’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like Parker-Hannifin is pretty sensible with its use of 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 Parker-Hannifin 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.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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.