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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Edgewell Personal Care Company (NYSE:EPC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.
What Is Edgewell Personal Care's Debt?
The chart below, which you can click on for greater detail, shows that Edgewell Personal Care had US$1.26b in debt in September 2020; about the same as the year before. However, it also had US$364.7m in cash, and so its net debt is US$894.3m.
A Look At Edgewell Personal Care's Liabilities
According to the last reported balance sheet, Edgewell Personal Care had liabilities of US$510.5m due within 12 months, and liabilities of US$1.60b due beyond 12 months. On the other hand, it had cash of US$364.7m and US$228.8m worth of receivables due within a year. So it has liabilities totalling US$1.51b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$1.81b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). 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).
Edgewell Personal Care's debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 4.2 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Another concern for investors might be that Edgewell Personal Care's EBIT fell 17% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Edgewell Personal Care 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Edgewell Personal Care recorded free cash flow worth 60% 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.
Mulling over Edgewell Personal Care's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Edgewell Personal Care's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Edgewell Personal Care (of which 1 is a bit unpleasant!) you should know about.
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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