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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Flowserve Corporation (NYSE:FLS) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Flowserve Carry?
The image below, which you can click on for greater detail, shows that Flowserve had debt of US$1.29b at the end of March 2021, a reduction from US$1.35b over a year. However, because it has a cash reserve of US$659.3m, its net debt is less, at about US$632.4m.
How Strong Is Flowserve’s Balance Sheet?
According to the last reported balance sheet, Flowserve had liabilities of US$1.08b due within 12 months, and liabilities of US$1.98b due beyond 12 months. Offsetting this, it had US$659.3m in cash and US$1.00b in receivables that were due within 12 months. So its liabilities total US$1.40b more than the combination of its cash and short-term receivables.
Flowserve has a market capitalization of US$5.47b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Flowserve’s low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.9 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. The good news is that Flowserve has increased its EBIT by 3.3% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Flowserve’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Flowserve produced sturdy free cash flow equating to 66% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
The good news is that Flowserve’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And its net debt to EBITDA is good too. Looking at all the aforementioned factors together, it strikes us that Flowserve can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. 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.