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 Avery Dennison Corporation (NYSE:AVY) makes use of debt. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Avery Dennison Carry?
As you can see below, Avery Dennison had US$1.91b of debt, at December 2019, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$283.9m, its net debt is less, at about US$1.63b.
How Strong Is Avery Dennison’s Balance Sheet?
We can see from the most recent balance sheet that Avery Dennison had liabilities of US$2.25b falling due within a year, and liabilities of US$2.03b due beyond that. On the other hand, it had cash of US$283.9m and US$1.21b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.79b.
This deficit isn’t so bad because Avery Dennison is worth US$6.56b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Avery Dennison’s net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its commanding EBIT of 10.8 times its interest expense, implies the debt load is as light as a peacock feather. Avery Dennison’s EBIT was pretty flat over the last year, but that shouldn’t be an issue given the it doesn’t have a lot of debt. 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 Avery Dennison’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.
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. In the last three years, Avery Dennison’s free cash flow amounted to 47% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
On our analysis Avery Dennison’s interest cover should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Avery Dennison’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Consider risks, for instance. Every company has them, and we’ve spotted 6 warning signs for Avery Dennison you should know about.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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