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.' 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, Johnson Controls International plc (NYSE:JCI) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.
How Much Debt Does Johnson Controls International Carry?
The image below, which you can click on for greater detail, shows that Johnson Controls International had debt of US$7.33b at the end of June 2019, a reduction from US$12.0b over a year. However, because it has a cash reserve of US$3.69b, its net debt is less, at about US$3.64b.
How Healthy Is Johnson Controls International's Balance Sheet?
We can see from the most recent balance sheet that Johnson Controls International had liabilities of US$9.24b falling due within a year, and liabilities of US$12.4b due beyond that. Offsetting these obligations, it had cash of US$3.69b as well as receivables valued at US$6.09b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$11.9b.
While this might seem like a lot, it is not so bad since Johnson Controls International has a huge market capitalization of US$33.4b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Johnson Controls International has a low net debt to EBITDA ratio of only 0.76. And its EBIT easily covers its interest expense, being 10.8 times the size. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Johnson Controls International has boosted its EBIT by 31%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Johnson Controls International's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Johnson Controls International created free cash flow amounting to 16% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Happily, Johnson Controls International's impressive EBIT growth rate implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Johnson Controls International can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Johnson Controls International insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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