Here's Why Methode Electronics (NYSE:MEI) Can Manage Its Debt Responsibly

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Methode Electronics, Inc. (NYSE:MEI) does carry debt. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Methode Electronics

How Much Debt Does Methode Electronics Carry?

As you can see below, Methode Electronics had US$210.5m of debt at April 2022, down from US$240.3m a year prior. However, because it has a cash reserve of US$172.0m, its net debt is less, at about US$38.5m.

How Healthy Is Methode Electronics' Balance Sheet?

We can see from the most recent balance sheet that Methode Electronics had liabilities of US$188.6m falling due within a year, and liabilities of US$286.7m due beyond that. On the other hand, it had cash of US$172.0m and US$281.6m worth of receivables due within a year. So it has liabilities totalling US$21.7m more than its cash and near-term receivables, combined.

Having regard to Methode Electronics' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$1.52b company is struggling for cash, we still think it's worth monitoring its balance sheet.

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.

Methode Electronics has a low net debt to EBITDA ratio of only 0.22. And its EBIT covers its interest expense a whopping 33.9 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Methode Electronics's EBIT dived 16%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Methode Electronics 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.

Finally, while the tax-man may adore accounting profits, lenders only accept 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, Methode Electronics produced sturdy free cash flow equating to 75% 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

Methode Electronics's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its EBIT growth rate has the opposite effect. Taking all this data into account, it seems to us that Methode Electronics takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Methode Electronics you should know about.

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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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.