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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Methode Electronics, Inc. (NYSE:MEI) does carry debt. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Methode Electronics's Debt?
You can click the graphic below for the historical numbers, but it shows that as of April 2019 Methode Electronics had US$292.6m of debt, an increase on US$57.8m, over one year. However, it does have US$83.2m in cash offsetting this, leading to net debt of about US$209.4m.
How Healthy Is Methode Electronics's Balance Sheet?
The latest balance sheet data shows that Methode Electronics had liabilities of US$180.9m due within a year, and liabilities of US$361.1m falling due after that. Offsetting these obligations, it had cash of US$83.2m as well as receivables valued at US$234.4m due within 12 months. So it has liabilities totalling US$224.4m more than its cash and near-term receivables, combined.
Given Methode Electronics has a market capitalization of US$1.19b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Methode Electronics's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 16.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Methode Electronics's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Methode Electronics's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Methode Electronics produced sturdy free cash flow equating to 63% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Methode Electronics's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! All these things considered, it appears that Methode Electronics can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Methode Electronics 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, 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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