David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We note that Home Depot, Inc. (NYSE:HD) has debt on its balance sheet. But the more important question is: what risk does this debt create?
What risk does debt carry?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. If things go really bad, lenders can take over the business. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Home Depot
What is Home Depot’s net debt?
The image below, which you can click on for more details, shows that in July 2022 Home Depot had $38.3 billion in debt, up from $33.1 billion in one year. However, he has $1.26 billion in cash to offset this, resulting in a net debt of approximately $37.0 billion.
How strong is Home Depot’s balance sheet?
The latest balance sheet data shows Home Depot had $27.8 billion in liabilities due within the year, and $47.8 billion in liabilities due thereafter. As compensation for these obligations, it had cash of US$1.26 billion as well as receivables valued at US$3.73 billion due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by $70.6 billion.
This deficit is not that bad because Home Depot is worth US$307.0 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. However, it is always worth taking a close look at its ability to repay debt.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Home Depot has a low net debt to EBITDA ratio of just 1.4. And its EBIT easily covers its interest costs, which is 17.2 times the size. So we’re pretty relaxed about his super-conservative use of debt. Fortunately, Home Depot has grown its EBIT by 8.5% over the past year, which makes this debt even more manageable. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Home Depot can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, The Home Depot has produced strong free cash flow equivalent to 62% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
The good news is that Home Depot’s demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. And its EBIT to free cash flow conversion is also good. Given all of this data, it seems to us that Home Depot is taking a pretty sensible approach to debt. This means they take on a bit more risk, hoping to increase shareholder returns. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. For example – Home Depot has 2 warning signs we think you should know.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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