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.' 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. We can see that Prestige Consumer Healthcare Inc. (NYSE:PBH) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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 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?
As you can see below, Prestige Consumer Healthcare had US$1.55b of debt at September 2020, down from US$1.75b a year prior. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Prestige Consumer Healthcare's Balance Sheet?
We can see from the most recent balance sheet that Prestige Consumer Healthcare had liabilities of US$136.1m falling due within a year, and liabilities of US$2.02b due beyond that. On the other hand, it had cash of US$26.6m and US$122.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.01b.
Given this deficit is actually higher than the company's market capitalization of US$1.86b, we think shareholders really should watch Prestige Consumer Healthcare's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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's debt is 4.5 times its EBITDA, and its EBIT cover its interest expense 3.5 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Fortunately, Prestige Consumer Healthcare grew its EBIT by 4.6% in the last year, slowly shrinking its debt relative to earnings. 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 Prestige Consumer Healthcare'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.
Finally, while the tax-man may adore accounting profits, lenders only accept 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, Prestige Consumer Healthcare recorded free cash flow worth 64% 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.
To be frank both Prestige Consumer Healthcare's level of total liabilities and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Prestige Consumer Healthcare stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that Prestige Consumer Healthcare is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...
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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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.