Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Amphenol Corporation (NYSE:APH) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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 Amphenol's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Amphenol had debt of US$3.97b, up from US$3.44b in one year. However, it also had US$997.3m in cash, and so its net debt is US$2.98b.
A Look At Amphenol's Liabilities
We can see from the most recent balance sheet that Amphenol had liabilities of US$2.05b falling due within a year, and liabilities of US$4.38b due beyond that. Offsetting these obligations, it had cash of US$997.3m as well as receivables valued at US$1.69b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.75b.
Since publicly traded Amphenol shares are worth a very impressive total of US$26.5b, it seems unlikely that this level of liabilities would be a major 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Amphenol's net debt is only 1.5 times its EBITDA. And its EBIT covers its interest expense a whopping 15.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. If Amphenol can keep growing EBIT at last year's rate of 10% over the last year, then it will find its debt load easier to manage. 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 Amphenol can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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, Amphenol recorded free cash flow worth 61% 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.
The good news is that Amphenol's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And its conversion of EBIT to free cash flow is good too. Taking all this data into account, it seems to us that Amphenol takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We'd be motivated to research the stock further if we found out that Amphenol insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.