Methode Electronics (NYSE:MEI) Has A Pretty Healthy Balance Sheet

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. We can see that Methode Electronics, Inc. (NYSE:MEI) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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.

View our latest analysis for Methode Electronics

What Is Methode Electronics's Debt?

As you can see below, Methode Electronics had US$204.0m of debt at October 2022, down from US$223.1m a year prior. However, it also had US$129.6m in cash, and so its net debt is US$74.4m.

How Healthy Is Methode Electronics' Balance Sheet?

We can see from the most recent balance sheet that Methode Electronics had liabilities of US$213.0m falling due within a year, and liabilities of US$282.5m due beyond that. Offsetting these obligations, it had cash of US$129.6m as well as receivables valued at US$321.0m due within 12 months. So its liabilities total US$44.9m more than the combination of its cash and short-term receivables.

Since publicly traded Methode Electronics shares are worth a total of US$1.67b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Methode Electronics's net debt is only 0.48 times its EBITDA. And its EBIT easily covers its interest expense, being 39.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Methode Electronics's load is not too heavy, because its EBIT was down 27% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 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. During the last three years, Methode Electronics produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Methode Electronics's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that Methode Electronics can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Methode Electronics is showing 1 warning sign in our investment analysis , 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.