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. We can see that Church & Dwight Co., Inc. (NYSE:CHD) does use debt in its business. But the real question is whether this debt is making the company risky.
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Church & Dwight's Net Debt?
As you can see below, at the end of December 2020, Church & Dwight had US$2.22b of debt, up from US$2.09b a year ago. Click the image for more detail. However, it does have US$183.1m in cash offsetting this, leading to net debt of about US$2.04b.
How Strong Is Church & Dwight's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Church & Dwight had liabilities of US$1.39b due within 12 months and liabilities of US$3.01b due beyond that. Offsetting these obligations, it had cash of US$183.1m as well as receivables valued at US$398.8m due within 12 months. So its liabilities total US$3.81b more than the combination of its cash and short-term receivables.
Since publicly traded Church & Dwight shares are worth a very impressive total of US$21.6b, 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Church & Dwight's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its commanding EBIT of 15.5 times its interest expense, implies the debt load is as light as a peacock feather. One way Church & Dwight could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, 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 Church & Dwight 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Church & Dwight recorded free cash flow worth a fulsome 93% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Happily, Church & Dwight's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think Church & Dwight's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Church & Dwight you should be aware of.
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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