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.’ 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 D.R. Horton, Inc. (NYSE:DHI) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is D.R. Horton’s Net Debt?
As you can see below, D.R. Horton had US$4.50b of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$2.11b in cash, and so its net debt is US$2.39b.
A Look At D.R. Horton’s Liabilities
Zooming in on the latest balance sheet data, we can see that D.R. Horton had liabilities of US$3.72b due within 12 months and liabilities of US$4.09b due beyond that. Offsetting this, it had US$2.11b in cash and US$257.1m in receivables that were due within 12 months. So it has liabilities totalling US$5.44b more than its cash and near-term receivables, combined.
Given D.R. Horton has a humongous market capitalization of US$32.6b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
D.R. Horton’s net debt is only 0.58 times its EBITDA. And its EBIT covers its interest expense a whopping 1k times over. So we’re pretty relaxed about its super-conservative use of debt. On top of that, D.R. Horton grew its EBIT by 71% over the last twelve months, and that growth will make it easier to handle its debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if D.R. Horton can strengthen its balance sheet over time.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, D.R. Horton recorded free cash flow of 24% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Our View
The good news is that D.R. Horton’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Taking all this data into account, it seems to us that D.R. Horton takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet.