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.' 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 Beazer Homes USA, Inc. (NYSE:BZH) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Beazer Homes USA's Debt?
You can click the graphic below for the historical numbers, but it shows that Beazer Homes USA had US$1.12b of debt in March 2021, down from US$1.43b, one year before. However, because it has a cash reserve of US$355.5m, its net debt is less, at about US$767.5m.
How Strong Is Beazer Homes USA's Balance Sheet?
The latest balance sheet data shows that Beazer Homes USA had liabilities of US$225.3m due within a year, and liabilities of US$1.20b falling due after that. Offsetting these obligations, it had cash of US$355.5m as well as receivables valued at US$26.4m due within 12 months. So its liabilities total US$1.04b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$669.1m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Beazer Homes USA would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
As it happens Beazer Homes USA has a fairly concerning net debt to EBITDA ratio of 6.0 but very strong interest coverage of 14.8. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, Beazer Homes USA grew its EBIT by 72% over the last twelve months, and that growth will make it easier to handle its debt. 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 Beazer Homes USA 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Beazer Homes USA actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Both Beazer Homes USA's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its net debt to EBITDA had us nibbling our nails. Looking at all this data makes us feel a little cautious about Beazer Homes USA's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should be aware of the 2 warning signs we've spotted with Beazer Homes USA .
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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