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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Prestige Consumer Healthcare Inc. (NYSE:PBH) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Prestige Consumer Healthcare's Debt?
You can click the graphic below for the historical numbers, but it shows that Prestige Consumer Healthcare had US$1.55b of debt in December 2020, down from US$1.70b, one year before. However, it also had US$62.1m in cash, and so its net debt is US$1.49b.
How Healthy Is Prestige Consumer Healthcare's Balance Sheet?
The latest balance sheet data shows that Prestige Consumer Healthcare had liabilities of US$126.2m due within a year, and liabilities of US$2.02b falling due after that. On the other hand, it had cash of US$62.1m and US$116.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.97b.
This deficit is considerable relative to its market capitalization of US$2.27b, so it does suggest shareholders should keep an eye on Prestige Consumer Healthcare's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Prestige Consumer Healthcare has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 3.6 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Prestige Consumer Healthcare improved its EBIT by 4.0% 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 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.
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. Over the most recent three years, Prestige Consumer Healthcare recorded free cash flow worth 65% 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.
While Prestige Consumer Healthcare's level of total liabilities makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. But its not so bad at converting EBIT to free cash flow. Taking the abovementioned factors together we do think Prestige Consumer Healthcare's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For example Prestige Consumer Healthcare has 2 warning signs (and 1 which doesn't sit too well with us) we think you should know about.
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.