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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Washington H. Soul Pattinson and Company Limited (ASX:SOL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Washington H. Soul Pattinson's Debt?
You can click the graphic below for the historical numbers, but it shows that as of January 2019 Washington H. Soul Pattinson had AU$243.9m of debt, an increase on AU$34.3m, over one year. However, because it has a cash reserve of AU$181.7m, its net debt is less, at about AU$62.3m.
How Strong Is Washington H. Soul Pattinson's Balance Sheet?
We can see from the most recent balance sheet that Washington H. Soul Pattinson had liabilities of AU$320.7m falling due within a year, and liabilities of AU$887.2m due beyond that. Offsetting these obligations, it had cash of AU$181.7m as well as receivables valued at AU$143.6m due within 12 months. So its liabilities total AU$882.6m more than the combination of its cash and short-term receivables.
Given Washington H. Soul Pattinson has a market capitalization of AU$5.00b, 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. Carrying virtually no net debt, Washington H. Soul Pattinson has a very light debt load indeed.
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). 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).
With debt at a measly 0.097 times EBITDA and EBIT covering interest a whopping 23.0 times, it's clear that Washington H. Soul Pattinson is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. But the bad news is that Washington H. Soul Pattinson has seen its EBIT plunge 16% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Washington H. Soul Pattinson 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Washington H. Soul Pattinson generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Washington H. Soul Pattinson's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its EBIT growth rate has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Washington H. Soul Pattinson 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. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Washington H. Soul Pattinson insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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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.