Is Avery Dennison (NYSE:AVY) A Risky Investment?

By
Simply Wall St
Published
February 17, 2022
NYSE:AVY
Source: Shutterstock

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. 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?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Avery Dennison

What Is Avery Dennison's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of January 2022 Avery Dennison had US$3.10b of debt, an increase on US$2.13b, over one year. However, because it has a cash reserve of US$162.7m, its net debt is less, at about US$2.94b.

debt-equity-history-analysis
NYSE:AVY Debt to Equity History February 17th 2022

How Strong Is Avery Dennison's Balance Sheet?

According to the last reported balance sheet, Avery Dennison had liabilities of US$2.55b due within 12 months, and liabilities of US$3.50b due beyond 12 months. Offsetting this, it had US$162.7m in cash and US$1.42b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.46b.

This deficit isn't so bad because Avery Dennison is worth a massive US$15.3b, and thus could probably raise enough capital to shore up 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 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 2.2 suggests only moderate use of debt. And its commanding EBIT of 15.2 times its interest expense, implies the debt load is as light as a peacock feather. Also relevant is that Avery Dennison has grown its EBIT by a very respectable 22% in the last year, thus enhancing its ability to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Avery Dennison 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Avery Dennison recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Avery Dennison's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. When we consider the range of factors above, it looks like Avery Dennison is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Avery Dennison .

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.

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