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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Air Products and Chemicals, Inc. ( NYSE:APD ) makes use of debt. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Air Products and Chemicals's Debt?
The chart below, which you can click on for greater detail, shows that Air Products and Chemicals had US$3.83b in debt in June 2019; about the same as the year before. However, it does have US$2.71b in cash offsetting this, leading to net debt of about US$1.12b.
How Healthy Is Air Products and Chemicals's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Air Products and Chemicals had liabilities of US$2.16b due within 12 months and liabilities of US$5.65b due beyond that. On the other hand, it had cash of US$2.71b and US$1.60b worth of receivables due within a year. So it has liabilities totalling US$3.50b more than its cash and near-term receivables, combined.
Given Air Products and Chemicals has a humongous market capitalization of US$50.4b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). 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).
Air Products and Chemicals's net debt is only 0.35 times its EBITDA. And its EBIT easily covers its interest expense, being 21.9 times the size. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that Air Products and Chemicals grew its EBIT by 12% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Air Products and Chemicals's ability to maintain a healthy balance sheet going forward. 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 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, Air Products and Chemicals's free cash flow amounted to 47% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
The good news is that Air Products and Chemicals's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And its net debt to EBITDA is good too. When we consider the range of factors above, it looks like Air Products and Chemicals is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. We'd be motivated to research the stock further if we found out that Air Products and Chemicals 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.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free , right now.
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