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

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.' 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?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. 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

How Much Debt Does Avery Dennison Carry?

The image below, which you can click on for greater detail, shows that Avery Dennison had debt of US$3.24b at the end of March 2024, a reduction from US$3.56b over a year. However, it also had US$221.7m in cash, and so its net debt is US$3.02b.

How Healthy Is Avery Dennison's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Avery Dennison had liabilities of US$3.31b due within 12 months and liabilities of US$2.74b due beyond that. Offsetting these obligations, it had cash of US$221.7m as well as receivables valued at US$1.48b due within 12 months. So its liabilities total US$4.35b more than the combination of its cash and short-term receivables.

Avery Dennison has a very large market capitalization of US$18.1b, so it could very likely raise cash to ameliorate 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 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 2.3 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.7 times interest expense) certainly does not do anything to dispel this impression. We saw Avery Dennison grow its EBIT by 4.3% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 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.

Our View

Avery Dennison's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think Avery Dennison is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Avery Dennison you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.