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.' 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 note that Prestige Consumer Healthcare Inc. (NYSE:PBH) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Prestige Consumer Healthcare's Net Debt?
The image below, which you can click on for greater detail, shows that Prestige Consumer Healthcare had debt of US$1.48b at the end of March 2021, a reduction from US$1.74b over a year. However, it also had US$32.3m in cash, and so its net debt is US$1.45b.
How Healthy Is Prestige Consumer Healthcare's Balance Sheet?
The latest balance sheet data shows that Prestige Consumer Healthcare had liabilities of US$122.1m due within a year, and liabilities of US$1.95b falling due after that. On the other hand, it had cash of US$32.3m and US$114.7m worth of receivables due within a year. So it has liabilities totalling US$1.92b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$2.83b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Prestige Consumer Healthcare has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 3.6 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The good news is that Prestige Consumer Healthcare improved its EBIT by 2.1% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Prestige Consumer Healthcare 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Prestige Consumer Healthcare produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Neither Prestige Consumer Healthcare's ability handle its debt, based on its EBITDA, nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We think that Prestige Consumer Healthcare's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. We've identified 1 warning sign with Prestige Consumer Healthcare , and understanding them should be part of your investment process.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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Prestige Consumer Healthcare
Prestige Consumer Healthcare Inc., together with its subsidiaries, develops, manufactures, markets, distributes, and sells over-the-counter (OTC) health and personal care products in the United States and internationally.
Undervalued with proven track record.