Avery Dennison (NYSE:AVY) Seems To Use Debt Quite Sensibly

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 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 Avery Dennison Corporation (NYSE:AVY) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Avery Dennison

What Is Avery Dennison's Net Debt?

As you can see below, Avery Dennison had US$3.22b of debt at June 2024, down from US$3.55b a year prior. However, it also had US$245.0m in cash, and so its net debt is US$2.97b.

How Healthy Is Avery Dennison's Balance Sheet?

According to the last reported balance sheet, Avery Dennison had liabilities of US$3.30b due within 12 months, and liabilities of US$2.71b due beyond 12 months. Offsetting this, it had US$245.0m in cash and US$1.53b in receivables that were due within 12 months. So its liabilities total US$4.24b more than the combination of its cash and short-term receivables.

Avery Dennison has a very large market capitalization of US$17.1b, so it could very likely raise cash to ameliorate 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 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). 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).

Avery Dennison's net debt of 2.1 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.4 times interest expense) certainly does not do anything to dispel this impression. If Avery Dennison can keep growing EBIT at last year's rate of 19% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Avery Dennison produced sturdy free cash flow equating to 57% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Avery Dennison's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its interest cover is also very heartening. Looking at all the aforementioned factors together, it strikes us that Avery Dennison can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Avery Dennison .

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.