Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘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. We can see that Tempur Sealy International, Inc. (NYSE:TPX) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 think about a company’s use of debt, we first look at cash and debt together.
What Is Tempur Sealy International’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Tempur Sealy International had US$1.58b of debt in June 2019, down from US$1.78b, one year before. However, it does have US$38.3m in cash offsetting this, leading to net debt of about US$1.54b.
A Look At Tempur Sealy International’s Liabilities
According to the last reported balance sheet, Tempur Sealy International had liabilities of US$738.7m due within 12 months, and liabilities of US$2.00b due beyond 12 months. Offsetting this, it had US$38.3m in cash and US$386.3m in receivables that were due within 12 months. So its liabilities total US$2.32b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Tempur Sealy International is worth US$4.11b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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).
Tempur Sealy International’s debt is 4.2 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Given the debt load, it’s hardly ideal that Tempur Sealy International’s EBIT was pretty flat over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Tempur Sealy International’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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Tempur Sealy International’s free cash flow amounted to 38% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
On the face of it, Tempur Sealy International’s interest cover left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Tempur Sealy International stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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