Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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. As with many other companies Park-Ohio Holdings Corp. (NASDAQ:PKOH) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Park-Ohio Holdings Carry?
The image below, which you can click on for greater detail, shows that Park-Ohio Holdings had debt of US$570.8m at the end of June 2019, a reduction from US$607.5m over a year. However, it does have US$45.3m in cash offsetting this, leading to net debt of about US$525.5m.
How Strong Is Park-Ohio Holdings's Balance Sheet?
We can see from the most recent balance sheet that Park-Ohio Holdings had liabilities of US$313.7m falling due within a year, and liabilities of US$680.4m due beyond that. On the other hand, it had cash of US$45.3m and US$288.4m worth of receivables due within a year. So its liabilities total US$660.4m more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$344.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Park-Ohio Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Park-Ohio Holdings's debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Fortunately, Park-Ohio Holdings grew its EBIT by 9.0% in the last year, slowly shrinking its debt relative to earnings. 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 Park-Ohio Holdings 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Park-Ohio Holdings reported free cash flow worth 15% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Mulling over Park-Ohio Holdings's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Park-Ohio Holdings's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given our concerns about Park-Ohio Holdings's debt levels, it seems only prudent to check if insiders have been ditching the stock.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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