The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. Importantly, Linde plc (NYSE:LIN) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Linde’s Debt?
You can click the graphic below for the historical numbers, but it shows that Linde had US$16.7b of debt in September 2021, down from US$17.7b, one year before. However, it also had US$4.70b in cash, and so its net debt is US$12.0b.
How Strong Is Linde’s Balance Sheet?
We can see from the most recent balance sheet that Linde had liabilities of US$14.8b falling due within a year, and liabilities of US$23.7b due beyond that. Offsetting this, it had US$4.70b in cash and US$4.53b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$29.2b.
Given Linde has a humongous market capitalization of US$165.3b, 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.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Linde has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 34.7 times over. So we’re pretty relaxed about its super-conservative use of debt. In addition to that, we’re happy to report that Linde has boosted its EBIT by 37%, thus reducing the spectre of future debt repayments. 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 Linde’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Linde generated free cash flow amounting to a very robust 94% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
The good news is that Linde’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 conversion of EBIT to free cash flow is also very heartening. Considering this range of factors, it seems to us that Linde is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. When analysing debt levels, the balance sheet is the obvious place to start.