Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Fortune Brands Home & Security, Inc. (NYSE:FBHS) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Fortune Brands Home & Security’s Net Debt?
As you can see below, at the end of June 2021, Fortune Brands Home & Security had US$2.61b of debt, up from US$2.25b a year ago. Click the image for more detail. However, it does have US$460.0m in cash offsetting this, leading to net debt of about US$2.15b.
NYSE:FBHS Debt to Equity History October 16th 2021
How Healthy Is Fortune Brands Home & Security’s Balance Sheet?
We can see from the most recent balance sheet that Fortune Brands Home & Security had liabilities of US$1.36b falling due within a year, and liabilities of US$3.29b due beyond that. Offsetting this, it had US$460.0m in cash and US$844.6m in receivables that were due within 12 months. So its liabilities total US$3.35b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Fortune Brands Home & Security is worth a massive US$13.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
Fortune Brands Home & Security’s net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its commanding EBIT of 12.7 times its interest expense, implies the debt load is as light as a peacock feather. Importantly, Fortune Brands Home & Security grew its EBIT by 38% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Fortune Brands Home & Security’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Fortune Brands Home & Security produced sturdy free cash flow equating to 70% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that Fortune Brands Home & Security’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think Fortune Brands Home & Security’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Fortune Brands Home & Security is showing 1 warning sign in our investment analysis , you should know about…
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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