Legendary fund manager Li Lu (whom Charlie Munger supported) once said, âThe biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. Like many other companies Patrick Industries, Inc. (NASDAQ: PATK) uses debt. But the most important question is: what risk does this debt create?
When is debt dangerous?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first step in examining a business’s debt levels is to consider its cash flow and debt together.
What is the debt of Patrick Industries?
As you can see below, at the end of September 2021, Patrick Industries was in debt of $ 1.09 billion, up from $ 686.8 million a year ago. Click on the image for more details. On the other hand, it has $ 44.9 million in cash, resulting in net debt of around $ 1.04 billion.
NasdaqGS: PATK History of debt to equity December 6, 2021
Is Patrick Industries’ balance sheet healthy?
According to the latest published balance sheet, Patrick Industries had liabilities of US $ 409.5 million due within 12 months and liabilities of US $ 1.26 billion due beyond 12 months. In compensation for these obligations, he had cash of US $ 44.9 million as well as receivables valued at US $ 292.9 million due within 12 months. Its liabilities therefore total US $ 1.33 billion more than the combination of its cash and short-term receivables.
This is a mountain of leverage compared to its market cap of US $ 1.97 billion. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Patrick Industries’ debt is 2.5 times its EBITDA, and its EBIT covers its interest expense 6.1 times. Overall, this implies that while we wouldn’t like to see debt levels rise, we believe it can handle its current leverage. Notably, Patrick Industries’ EBIT was higher than Elon Musk’s, gaining a whopping 115% from last year. The balance sheet is clearly the area to focus on when analyzing debt. But it is ultimately the future profitability of the company that will decide whether Patrick Industries can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts‘ earnings forecasts.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. We must therefore clearly examine whether this EBIT leads to the corresponding free cash flow. Over the past three years, Patrick Industries has generated strong free cash flow equivalent to 74% of its EBIT, roughly what we expected. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
Patrick Industries’ EBIT growth rate suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. But frankly, we think his total passive level undermines that feeling a bit. All these things considered, it looks like Patrick Industries can comfortably manage their current level of debt. Of course, while this leverage can improve returns on equity, it comes with more risk, so it’s worth keeping an eye out for. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. To this end, you should inquire about the 3 warning signs we spotted it with Patrick Industries (including 1 which is significant).
If you want to invest in companies that can generate profits without the burden of debt, check out this free list of growing companies that have net cash on the balance sheet.
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