Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Parker-Hannifin Corporation (NYSE:PH) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Parker-Hannifin Carry?
As you can see below, at the end of June 2019, Parker-Hannifin had US$7.11b of debt, up from US$4.96b a year ago. Click the image for more detail. However, it does have US$3.37b in cash offsetting this, leading to net debt of about US$3.74b.
How Healthy Is Parker-Hannifin's Balance Sheet?
We can see from the most recent balance sheet that Parker-Hannifin had liabilities of US$3.15b falling due within a year, and liabilities of US$8.46b due beyond that. On the other hand, it had cash of US$3.37b and US$2.44b worth of receivables due within a year. So its liabilities total US$5.80b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Parker-Hannifin has a huge market capitalization of US$22.0b, 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 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.
Parker-Hannifin's net debt is only 1.5 times its EBITDA. And its EBIT covers its interest expense a whopping 12.1 times over. So we're pretty relaxed about its super-conservative use of debt. We saw Parker-Hannifin grow its EBIT by 5.8% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 Parker-Hannifin'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 company can only pay off debt with cold hard cash, not accounting profits. 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, Parker-Hannifin produced sturdy free cash flow equating to 73% 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.
Parker-Hannifin's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Taking all this data into account, it seems to us that Parker-Hannifin takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We'd be motivated to research the stock further if we found out that Parker-Hannifin 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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