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.' 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. We note that Colgate-Palmolive Company (NYSE:CL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 Colgate-Palmolive's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Colgate-Palmolive had US$7.19b of debt in March 2021, down from US$7.85b, one year before. On the flip side, it has US$1.06b in cash leading to net debt of about US$6.13b.
How Healthy Is Colgate-Palmolive's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Colgate-Palmolive had liabilities of US$4.54b due within 12 months and liabilities of US$10.6b due beyond that. On the other hand, it had cash of US$1.06b and US$1.40b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$12.7b.
Since publicly traded Colgate-Palmolive shares are worth a very impressive total of US$67.9b, 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Colgate-Palmolive's net debt is only 1.4 times its EBITDA. And its EBIT covers its interest expense a whopping 24.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Colgate-Palmolive grew its EBIT by 4.7% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Colgate-Palmolive 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Colgate-Palmolive produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Colgate-Palmolive's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think Colgate-Palmolive's use of debt seems quite reasonable and we're not concerned about it. 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. For instance, we've identified 2 warning signs for Colgate-Palmolive that you should be aware of.
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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