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 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. Importantly, D.R. Horton, Inc. (NYSE:DHI) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is D.R. Horton's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 D.R. Horton had US$3.45b of debt, an increase on US$3.09b, over one year. However, it does have US$819.5m in cash offsetting this, leading to net debt of about US$2.63b.
How Healthy Is D.R. Horton's Balance Sheet?
The latest balance sheet data shows that D.R. Horton had liabilities of US$2.13b due within a year, and liabilities of US$3.28b falling due after that. On the other hand, it had cash of US$819.5m and US$177.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.41b.
While this might seem like a lot, it is not so bad since D.R. Horton has a huge market capitalization of US$17.7b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
D.R. Horton has a low net debt to EBITDA ratio of only 1.3. And its EBIT covers its interest expense a whopping 1k times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, D.R. Horton grew its EBIT by 5.0% in the last year, making that debt load look even more manageable. 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 D.R. Horton 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, D.R. Horton's free cash flow amounted to 20% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On our analysis D.R. Horton's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about D.R. Horton's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. We'd be motivated to research the stock further if we found out that D.R. Horton insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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