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, M/I Homes, Inc. (NYSE:MHO) does carry debt. But is this debt a concern to shareholders?

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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is M/I Homes’s Debt?

As you can see below, M/I Homes had US$814.1m of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$373.5m, its net debt is less, at about US$440.6m.

How Healthy Is M/I Homes’ Balance Sheet?

The latest balance sheet data shows that M/I Homes had liabilities of US$432.1m due within a year, and liabilities of US$962.8m falling due after that. Offsetting these obligations, it had cash of US$373.5m as well as receivables valued at US$22.2m due within 12 months. So its liabilities total US$999.2m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since M/I Homes has a market capitalization of US$1.81b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

M/I Homes has a low net debt to EBITDA ratio of only 0.95. And its EBIT easily covers its interest expense, being 406 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, M/I Homes grew its EBIT by 97% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if M/I Homes can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, M/I Homes’s free cash flow amounted to 48% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that M/I Homes’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. Looking at all the aforementioned factors together, it strikes us that M/I Homes 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.