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.’ 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. As with many other companies Mohawk Industries, Inc. (NYSE:MHK) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Mohawk Industries’s Net Debt?
The chart below, which you can click on for greater detail, shows that Mohawk Industries had US$2.63b in debt in July 2021; about the same as the year before. However, it also had US$1.42b in cash, and so its net debt is US$1.22b.
How Strong Is Mohawk Industries’ Balance Sheet?
We can see from the most recent balance sheet that Mohawk Industries had liabilities of US$3.18b falling due within a year, and liabilities of US$2.84b due beyond that. Offsetting these obligations, it had cash of US$1.42b as well as receivables valued at US$2.02b due within 12 months. So its liabilities total US$2.59b more than the combination of its cash and short-term receivables.
Given Mohawk Industries has a humongous market capitalization of US$13.8b, it’s hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
Mohawk Industries has a low net debt to EBITDA ratio of only 0.63. And its EBIT easily covers its interest expense, being 23.1 times the size. So we’re pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Mohawk Industries grew its EBIT by 114% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Mohawk Industries can strengthen its balance sheet over time.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Mohawk Industries generated free cash flow amounting to a very robust 96% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Our View
Happily, Mohawk Industries’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Considering this range of factors, it seems to us that Mohawk Industries is quite prudent with its debt, and the risks seem well managed. So we’re not worried about the use of a little leverage on the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt.