Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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 can see that Illinois Tool Works Inc. (NYSE:ITW) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Illinois Tool Works’s Debt?

As you can see below, Illinois Tool Works had US$7.65b of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$2.06b in cash offsetting this, leading to net debt of about US$5.59b.

A Look At Illinois Tool Works’ Liabilities

Zooming in on the latest balance sheet data, we can see that Illinois Tool Works had liabilities of US$2.96b due within 12 months and liabilities of US$9.10b due beyond that. On the other hand, it had cash of US$2.06b and US$2.79b worth of receivables due within a year. So it has liabilities totalling US$7.22b more than its cash and near-term receivables, combined.

Given Illinois Tool Works has a humongous market capitalization of US$72.6b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Illinois Tool Works has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 18.3 times over. So we’re pretty relaxed about its super-conservative use of debt. Also good is that Illinois Tool Works grew its EBIT at 19% over the last year, further increasing its ability to manage debt. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Illinois Tool Works’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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Illinois Tool Works recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Illinois Tool Works’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think Illinois Tool Works’s use of debt seems quite reasonable and we’re not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt.