Is Home Depot (NYSE:HD) Using Too Much Debt?

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 The Home Depot, Inc. (NYSE:HD) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Home Depot

What Is Home Depot's Net Debt?

As you can see below, Home Depot had US$39.0b of debt, at April 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$1.26b in cash, and so its net debt is US$37.7b.

How Healthy Is Home Depot's Balance Sheet?

We can see from the most recent balance sheet that Home Depot had liabilities of US$25.4b falling due within a year, and liabilities of US$50.6b due beyond that. Offsetting this, it had US$1.26b in cash and US$4.21b in receivables that were due within 12 months. So it has liabilities totalling US$70.6b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Home Depot has a huge market capitalization of US$335.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Home Depot's net debt is only 1.4 times its EBITDA. And its EBIT covers its interest expense a whopping 14.5 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Home Depot grew its EBIT by 2.0% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Home Depot's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, Home Depot produced sturdy free cash flow equating to 60% 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.

Our View

The good news is that Home Depot's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And its conversion of EBIT to free cash flow is good too. All these things considered, it appears that Home Depot can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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, we've discovered 1 warning sign for Home Depot that you should be aware of before investing here.

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.