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. As with many other companies James Hardie Industries plc (ASX:JHX) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does James Hardie Industries Carry?
As you can see below, at the end of June 2019, James Hardie Industries had US$1.31b of debt, up from US$1.25b a year ago. Click the image for more detail. However, it does have US$96.1m in cash offsetting this, leading to net debt of about US$1.21b.
How Healthy Is James Hardie Industries's Balance Sheet?
According to the last reported balance sheet, James Hardie Industries had liabilities of US$632.1m due within 12 months, and liabilities of US$2.53b due beyond 12 months. Offsetting these obligations, it had cash of US$96.1m as well as receivables valued at US$262.8m due within 12 months. So it has liabilities totalling US$2.81b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since James Hardie Industries has a market capitalization of US$6.81b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). 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 a debt to EBITDA ratio of 2.2, James Hardie Industries uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.9 times interest expense) certainly does not do anything to dispel this impression. Importantly James Hardie Industries's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if James Hardie Industries 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, James Hardie Industries reported free cash flow worth 20% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Neither James Hardie Industries's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But it seems to be able to cover its interest expense with its EBIT without much trouble. Looking at all the angles mentioned above, it does seem to us that James Hardie Industries is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of James Hardie Industries's earnings per share history for free.
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.
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