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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Oil-Dri Corporation of America (NYSE:ODC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Oil-Dri of America's Debt?
The image below, which you can click on for greater detail, shows that Oil-Dri of America had debt of US$6.13m at the end of April 2019, a reduction from US$15.2m over a year. But on the other hand it also has US$17.0m in cash, leading to a US$10.8m net cash position.
How Strong Is Oil-Dri of America's Balance Sheet?
We can see from the most recent balance sheet that Oil-Dri of America had liabilities of US$31.5m falling due within a year, and liabilities of US$29.5m due beyond that. Offsetting this, it had US$17.0m in cash and US$35.9m in receivables that were due within 12 months. So it has liabilities totalling US$8.10m more than its cash and near-term receivables, combined.
Since publicly traded Oil-Dri of America shares are worth a total of US$218.2m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Oil-Dri of America boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Oil-Dri of America if management cannot prevent a repeat of the 39% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Oil-Dri of America will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Oil-Dri of America has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Oil-Dri of America's free cash flow amounted to 38% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Oil-Dri of America has US$11m in net cash. So we don't have any problem with Oil-Dri of America's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Oil-Dri of America insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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If you spot an error that warrants correction, please contact the editor at 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.