The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. As with many other companies Spectrum Brands Holdings, Inc. (NYSE:SPB) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Spectrum Brands Holdings’s Net Debt?
As you can see below, Spectrum Brands Holdings had US$2.17b of debt at December 2019, down from US$4.55b a year prior. On the flip side, it has US$142.2m in cash leading to net debt of about US$2.03b.
How Healthy Is Spectrum Brands Holdings’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Spectrum Brands Holdings had liabilities of US$1.00b due within 12 months and liabilities of US$2.57b due beyond that. Offsetting these obligations, it had cash of US$142.2m as well as receivables valued at US$562.1m due within 12 months. So it has liabilities totalling US$2.87b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company’s market capitalization of US$2.65b, we think shareholders really should watch Spectrum Brands Holdings’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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.
While we wouldn’t worry about Spectrum Brands Holdings’s net debt to EBITDA ratio of 4.3, we think its super-low interest cover of 1.6 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Another concern for investors might be that Spectrum Brands Holdings’s EBIT fell 13% 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. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Spectrum Brands Holdings’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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Spectrum Brands Holdings produced sturdy free cash flow equating to 65% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Mulling over Spectrum Brands Holdings’s attempt at covering its interest expense with its EBIT, we’re certainly not enthusiastic. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We’re quite clear that we consider Spectrum Brands Holdings to be really rather risky, as a result of its balance sheet health. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. 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. Be aware that Spectrum Brands Holdings is showing 2 warning signs in our investment analysis , you should know about…
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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