Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Hillenbrand, Inc. (NYSE:HI) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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. 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 Hillenbrand's Net Debt?
As you can see below, Hillenbrand had US$324.4m of debt at June 2019, down from US$424.4m a year prior. However, it also had US$64.4m in cash, and so its net debt is US$260.0m.
A Look At Hillenbrand's Liabilities
Zooming in on the latest balance sheet data, we can see that Hillenbrand had liabilities of US$526.3m due within 12 months and liabilities of US$568.5m due beyond that. On the other hand, it had cash of US$64.4m and US$357.4m worth of receivables due within a year. So it has liabilities totalling US$673.0m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Hillenbrand is worth US$1.70b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Hillenbrand has a low net debt to EBITDA ratio of only 0.90. And its EBIT easily covers its interest expense, being 10.7 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Hillenbrand saw its EBIT drop by 5.4% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hillenbrand can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept 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, Hillenbrand generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
The good news is that Hillenbrand's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But truth be told we feel its EBIT growth rate does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Hillenbrand can handle its debt fairly comfortably. 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. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Hillenbrand's dividend history, without delay!
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.
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