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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that The Procter & Gamble Company (NYSE:PG) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Procter & Gamble Carry?
As you can see below, Procter & Gamble had US$32.5b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$10.4b in cash, and so its net debt is US$22.2b.
How Healthy Is Procter & Gamble's Balance Sheet?
We can see from the most recent balance sheet that Procter & Gamble had liabilities of US$36.6b falling due within a year, and liabilities of US$36.7b due beyond that. Offsetting this, it had US$10.4b in cash and US$5.66b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$57.2b.
Since publicly traded Procter & Gamble shares are worth a very impressive total of US$355.3b, it seems unlikely that this level of liabilities would be a major 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).
Procter & Gamble has a low net debt to EBITDA ratio of only 1.0. And its EBIT easily covers its interest expense, being 43.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Procter & Gamble grew its EBIT by 3.5% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Procter & Gamble'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Procter & Gamble recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Our View
The good news is that Procter & Gamble's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Zooming out, Procter & Gamble seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Procter & Gamble you should know about.
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.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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