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.’ 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. We can see that PulteGroup, Inc. (NYSE:PHM) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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, 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.
What Is PulteGroup’s Net Debt?
The image below, which you can click on for greater detail, shows that PulteGroup had debt of US$2.54b at the end of September 2021, a reduction from US$3.03b over a year. On the flip side, it has US$1.58b in cash leading to net debt of about US$956.7m.
How Strong Is PulteGroup’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that PulteGroup had liabilities of US$2.33b due within 12 months and liabilities of US$3.10b due beyond that. Offsetting these obligations, it had cash of US$1.58b as well as receivables valued at US$67.8m due within 12 months. So it has liabilities totalling US$3.78b more than its cash and near-term receivables, combined.
PulteGroup has a very large market capitalization of US$13.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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). 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).
PulteGroup has a low debt to EBITDA ratio of only 0.41. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there’s no doubt this company can take on debt while staying cool as a cucumber. In addition to that, we’re happy to report that PulteGroup has boosted its EBIT by 33%, 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 PulteGroup’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, PulteGroup recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
PulteGroup’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think PulteGroup’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity.