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. We can see that WD-40 Company (NASDAQ:WDFC) does use debt in its business. But is this debt a concern to shareholders?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.

What Is WD-40’s Net Debt?

The chart below, which you can click on for greater detail, shows that WD-40 had US$115.7m in debt in August 2021; about the same as the year before. However, because it has a cash reserve of US$86.0m, its net debt is less, at about US$29.8m.

How Strong Is WD-40’s Balance Sheet?

We can see from the most recent balance sheet that WD-40 had liabilities of US$85.9m falling due within a year, and liabilities of US$143.9m due beyond that. Offsetting this, it had US$86.0m in cash and US$89.6m in receivables that were due within 12 months. So its liabilities total US$54.3m more than the combination of its cash and short-term receivables.

Having regard to WD-40’s size, it seems that its liquid assets are well balanced with its total liabilities. So while it’s hard to imagine that the US$3.30b company is struggling for cash, we still think it’s worth monitoring its balance sheet. But either way, WD-40 has virtually no net debt, so it’s fair to say it does not have a heavy debt load!

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).

WD-40’s net debt is only 0.31 times its EBITDA. And its EBIT covers its interest expense a whopping 38.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that WD-40 grew its EBIT by 15% last year, making its debt load easier to handle. 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 WD-40’s ability to maintain a healthy balance sheet going forward.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, WD-40 produced sturdy free cash flow equating to 69% 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 WD-40’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Overall, we don’t think WD-40 is taking any bad risks, as its debt load seems modest. So we’re not worried about the use of a little leverage on the balance sheet.