David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Ethan Allen Interiors Inc. (NYSE:ETH) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Ethan Allen Interiors's Net Debt?
The image below, which you can click on for greater detail, shows that at March 2020 Ethan Allen Interiors had debt of US$100.0m, up from US$8.00m in one year. But on the other hand it also has US$116.9m in cash, leading to a US$16.9m net cash position.
A Look At Ethan Allen Interiors's Liabilities
The latest balance sheet data shows that Ethan Allen Interiors had liabilities of US$146.9m due within a year, and liabilities of US$217.0m falling due after that. On the other hand, it had cash of US$116.9m and US$10.5m worth of receivables due within a year. So its liabilities total US$236.5m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$297.6m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Ethan Allen Interiors also has more cash than debt, so we're pretty confident it can manage its debt safely.
In fact Ethan Allen Interiors's saving grace is its low debt levels, because its EBIT has tanked 33% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Ethan Allen Interiors 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. Ethan Allen Interiors may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Ethan Allen Interiors generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
While Ethan Allen Interiors does have more liabilities than liquid assets, it also has net cash of US$16.9m. And it impressed us with free cash flow of US$35m, being 87% of its EBIT. So we don't have any problem with Ethan Allen Interiors's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - Ethan Allen Interiors has 4 warning signs we think 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.
Love or hate this article? Concerned about the content? Get in touch with us directly. Alternatively, email firstname.lastname@example.org.
This article by Simply Wall St is general in nature. 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. Thank you for reading.