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.' 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 Littelfuse, Inc. (NASDAQ:LFUS) 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Littelfuse's Debt?
The chart below, which you can click on for greater detail, shows that Littelfuse had US$686.9m in debt in June 2019; about the same as the year before. However, it also had US$474.8m in cash, and so its net debt is US$212.1m.
How Healthy Is Littelfuse's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Littelfuse had liabilities of US$266.4m due within 12 months and liabilities of US$845.2m due beyond that. On the other hand, it had cash of US$474.8m and US$245.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$391.1m.
Of course, Littelfuse has a market capitalization of US$3.73b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
Littelfuse's net debt is only 0.62 times its EBITDA. And its EBIT easily covers its interest expense, being 10.6 times the size. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that Littelfuse saw its EBIT decline by 4.9% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Littelfuse's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Littelfuse generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Happily, Littelfuse's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its EBIT growth rate. Taking all this data into account, it seems to us that Littelfuse takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. We'd be motivated to research the stock further if we found out that Littelfuse 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, 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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