David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Pool Corporation (NASDAQ:POOL) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Pool’s Debt?

The image below, which you can click on for greater detail, shows that Pool had debt of US$435.2m at the end of June 2021, a reduction from US$453.8m over a year. However, it does have US$63.1m in cash offsetting this, leading to net debt of about US$372.1m.

How Healthy Is Pool’s Balance Sheet?

The latest balance sheet data shows that Pool had liabilities of US$697.7m due within a year, and liabilities of US$641.6m falling due after that. Offsetting this, it had US$63.1m in cash and US$585.6m in receivables that were due within 12 months. So its liabilities total US$690.6m more than the combination of its cash and short-term receivables.

Given Pool has a humongous market capitalization of US$17.5b, 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Pool has a low net debt to EBITDA ratio of only 0.52. And its EBIT covers its interest expense a whopping 88.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Pool grew its EBIT by 82% 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 it is future earnings, more than anything, that will determine Pool’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, Pool 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 Pool’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 EBIT growth rate also supports that impression! Overall, we don’t think Pool 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. The balance sheet is clearly the area to focus on when you are analysing debt.