Is Parker-Hannifin (NYSE:PH) using too much debt?

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Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We note that Parker-Hannifin Corporation (NYSE:PH) has debt on its balance sheet. But should shareholders worry about its use of debt?

Why is debt risky?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.

Check out our latest analysis for Parker-Hannifin

What is Parker-Hannifin’s debt?

You can click on the graph below for historical numbers, but it shows that in December 2021, Parker-Hannifin had $8.45 billion in debt, an increase from $7.21 billion, on a year. On the other hand, it has $490.0 million in cash, resulting in a net debt of around $7.96 billion.

NYSE: PH Debt to Equity February 24, 2022

How strong is Parker-Hannifin’s balance sheet?

According to the last published balance sheet, Parker-Hannifin had liabilities of $5.26 billion maturing within 12 months and liabilities of $8.37 billion maturing beyond 12 months. In compensation for these obligations, it had cash of US$490.0 million as well as receivables valued at US$2.36 billion and maturing within 12 months. Thus, its liabilities total $10.8 billion more than the combination of its cash and short-term receivables.

Parker-Hannifin has a very large market capitalization of $37.2 billion, so it could very likely raise funds to improve its balance sheet, should the need arise. However, it is always worth taking a close look at your ability to repay debt.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

We would say that Parker-Hannifin’s moderate net debt to EBITDA ratio (2.4) is indicative of leverage caution. And its towering EBIT of 11.5 times its interest expense means that the debt burden is as light as a peacock feather. Above all, Parker-Hannifin has increased its EBIT by 31% over the last twelve months, and this growth will make it easier to manage its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Parker-Hannifin can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, a business needs free cash flow to pay off its debts; book profits are not enough. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Parker-Hannifin has generated free cash flow of a very strong 91% of EBIT, more than we expected. This puts him in a very strong position to pay off the debt.

Our point of view

Fortunately, Parker-Hannifin’s impressive EBIT to free cash flow conversion means it has the upper hand on its debt. But, on a darker note, we’re a bit concerned about its net debt to EBITDA. Zooming out, Parker-Hannifin seems to be using debt quite sensibly; and that gets the green light from us. After all, reasonable leverage can increase return on equity. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 2 warning signs for Parker-Hannifin you should know.

If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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