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. As with many other companies Prestige Consumer Healthcare Inc. (NYSE:PBH) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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.
What Is Prestige Consumer Healthcare's Net Debt?
As you can see below, Prestige Consumer Healthcare had US$1.55b of debt at June 2021, down from US$1.63b a year prior. However, because it has a cash reserve of US$163.6m, its net debt is less, at about US$1.38b.
A Look At Prestige Consumer Healthcare's Liabilities
We can see from the most recent balance sheet that Prestige Consumer Healthcare had liabilities of US$125.0m falling due within a year, and liabilities of US$2.02b due beyond that. Offsetting these obligations, it had cash of US$163.6m as well as receivables valued at US$130.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.85b.
This deficit is considerable relative to its market capitalization of US$3.07b, 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 4.1 and its EBIT covered its interest expense 4.1 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Fortunately, Prestige Consumer Healthcare grew its EBIT by 2.9% in the last year, slowly shrinking its debt relative to earnings. 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 Prestige Consumer Healthcare 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 always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Prestige Consumer Healthcare recorded free cash flow worth 67% 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.
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 the good news is it seems to be able to convert EBIT to free cash flow with ease. Looking at all the angles mentioned above, it does seem to us that Prestige Consumer Healthcare is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 1 warning sign for Prestige Consumer Healthcare you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.