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.' 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, Reece Limited (ASX:REH) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Reece Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Reece had debt of AU$1.64b, up from none in one year. On the flip side, it has AU$127.9m in cash leading to net debt of about AU$1.51b.
How Strong Is Reece's Balance Sheet?
The latest balance sheet data shows that Reece had liabilities of AU$793.2m due within a year, and liabilities of AU$1.69b falling due after that. Offsetting these obligations, it had cash of AU$127.9m as well as receivables valued at AU$864.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$1.49b.
This deficit isn't so bad because Reece is worth AU$5.72b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Reece's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 4.6 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. If Reece can keep growing EBIT at last year's rate of 17% over the last year, then it will find its debt load easier to manage. 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 Reece'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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Reece's free cash flow amounted to 36% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
On our analysis Reece's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit handle its debt, based on its EBITDA,. When we consider all the factors mentioned above, we do feel a bit cautious about Reece's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in Reece, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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