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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Eaton Corporation plc (NYSE:ETN) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is Eaton's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Eaton had US$8.10b of debt, an increase on US$7.74b, over one year. However, it does have US$797.0m in cash offsetting this, leading to net debt of about US$7.30b.
How Strong Is Eaton's Balance Sheet?
According to the last reported balance sheet, Eaton had liabilities of US$4.45b due within 12 months, and liabilities of US$11.4b due beyond 12 months. Offsetting this, it had US$797.0m in cash and US$4.04b in receivables that were due within 12 months. So its liabilities total US$11.0b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Eaton has a huge market capitalization of US$34.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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).
Eaton's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 11.6 times its interest expense, implies the debt load is as light as a peacock feather. If Eaton can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Eaton 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Eaton generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Happily, Eaton's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its interest cover also supports that impression! When we consider the range of factors above, it looks like Eaton is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Eaton 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.