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.’ 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 Hillenbrand, Inc. (NYSE:HI) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Hillenbrand’s Debt?
As you can see below, Hillenbrand had US$1.21b of debt, at March 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$444.8m in cash leading to net debt of about US$769.2m.
How Healthy Is Hillenbrand’s Balance Sheet?
We can see from the most recent balance sheet that Hillenbrand had liabilities of US$1.07b falling due within a year, and liabilities of US$1.71b due beyond that. Offsetting these obligations, it had cash of US$444.8m as well as receivables valued at US$479.5m due within 12 months. So its liabilities total US$1.86b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of US$2.79b, so it does suggest shareholders should keep an eye on Hillenbrand’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Hillenbrand’s low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.2 times last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. While Hillenbrand doesn’t seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hillenbrand can strengthen its balance sheet over time.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Hillenbrand recorded free cash flow worth a fulsome 90% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
Our View
On our analysis Hillenbrand’s conversion of EBIT to free cash flow should signal that it won’t have too much trouble with its debt. However, our other observations weren’t so heartening. For instance it seems like it has to struggle a bit to handle its total liabilities. Considering this range of data points, we think Hillenbrand is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There’s no doubt that we learn most about debt from the balance sheet.