David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We note that Donaldson Company, Inc. (NYSE:DCI) has debt on its balance sheet. But does this debt worry shareholders?
When is debt a problem?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. By replacing dilution, however, debt can be a great tool for companies 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.
See our latest analysis for Donaldson Company
How much debt does Donaldson Company have?
You can click on the chart below for historical numbers, but it shows that in April 2022, Donaldson Company had $638.5 million in debt, up from $499.1 million, on a year. However, he has $168.7 million in cash to offset this, resulting in a net debt of approximately $469.8 million.
How healthy is Donaldson Company’s balance sheet?
The latest balance sheet data shows Donaldson Company had liabilities of $606.5 million due within the year, and liabilities of $789.1 million due thereafter. In return, he had $168.7 million in cash and $604.2 million in receivables due within 12 months. Thus, its liabilities total $622.7 million more than the combination of its cash and short-term receivables.
Given that Donaldson Company has a market capitalization of US$5.69 billion, it’s hard to believe that these liabilities pose much of a threat. But there are enough liabilities that we certainly recommend that shareholders continue to monitor the balance sheet in the future.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Donaldson Company’s net debt is only 0.91 times its EBITDA. And its EBIT covers its interest charges 30.3 times. So we’re pretty relaxed about his super-conservative use of debt. And we also warmly note that Donaldson Company increased its EBIT by 13% last year, which makes it easier to manage its debt. The balance sheet is clearly the area to focus on when analyzing debt. But future earnings, more than anything, will determine Donaldson Company’s ability to maintain a healthy balance sheet in the future. 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. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Donaldson Company has had free cash flow of 67% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
The good news is that Donaldson Company’s demonstrated ability to cover interest costs with EBIT delights us like a fluffy puppy does a toddler. And this is only the beginning of good news since its conversion of EBIT into free cash flow is also very pleasing. Overall, we think Donaldson Company’s use of debt seems entirely reasonable and we are not concerned about that. Although debt carries risks, when used wisely, it can also generate a higher 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. Example: we have identified 1 warning sign for Donaldson Company you should be aware.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
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.