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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Herman Miller, Inc. (NASDAQ:MLHR) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Herman Miller Carry?
The image below, which you can click on for greater detail, shows that Herman Miller had debt of US$259.7m at the end of February 2021, a reduction from US$294.8m over a year. However, its balance sheet shows it holds US$404.9m in cash, so it actually has US$145.2m net cash.
A Look At Herman Miller's Liabilities
We can see from the most recent balance sheet that Herman Miller had liabilities of US$499.9m falling due within a year, and liabilities of US$645.8m due beyond that. Offsetting this, it had US$404.9m in cash and US$219.8m in receivables that were due within 12 months. So it has liabilities totalling US$521.0m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Herman Miller is worth US$2.47b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Herman Miller also has more cash than debt, so we're pretty confident it can manage its debt safely.
But the other side of the story is that Herman Miller saw its EBIT decline by 9.5% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Herman Miller's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Herman Miller may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Herman Miller recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While Herman Miller does have more liabilities than liquid assets, it also has net cash of US$145.2m. And it impressed us with free cash flow of US$221m, being 78% of its EBIT. So we are not troubled with Herman Miller's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Herman Miller is showing 1 warning sign in our investment analysis , 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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