Warren Buffett famously said, 'Volatility is far from synonymous with risk.'  It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses.  Importantly, Kennametal Inc. (NYSE:KMT) does carry debt.  But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow.  Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers.  However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control.  Of course, plenty of companies use debt to fund growth, without any negative consequences.  The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Kennametal

How Much Debt Does Kennametal Carry?

You can click the graphic below for the historical numbers, but it shows that Kennametal had US$626.6m of debt in September 2023, down from US$679.8m, one year before.    However, it also had US$95.1m in cash, and so its net debt is US$531.5m.  

NYSE:KMT Debt to Equity History January 4th 2024

How Strong Is Kennametal's Balance Sheet?

We can see from the most recent balance sheet that Kennametal had liabilities of US$419.8m falling due within a year, and liabilities of US$794.2m due beyond that.   Offsetting this, it had US$95.1m in cash and US$288.7m in receivables that were due within 12 months.   So its liabilities total US$830.3m more than the combination of its cash and short-term receivables.  

Kennametal has a market capitalization of US$1.96b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose.  But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.  

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).  This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Kennametal's net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 7.0 times last year.   While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden.         On the other hand, Kennametal's EBIT dived 13%, over the last year.  We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock.       When analysing debt levels, the balance sheet is the obvious place to start.  But ultimately the future profitability of the business will decide if Kennametal can strengthen its balance sheet over time.  So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.  

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash.   So we always check how much of that EBIT is translated into free cash flow.    Over the most recent three years, Kennametal recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax.  This free cash flow puts the company in a good position to pay down debt, when appropriate.  

Our View

Kennametal's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming.   But on the bright side, its ability to to convert EBIT to free cash flow isn't too shabby at all.       Looking at all the angles mentioned above, it does seem to us that Kennametal is a somewhat risky investment as a result of its debt.  That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of.    When analysing debt levels, the balance sheet is the obvious place to start.  However, not all investment risk resides within the balance sheet - far from it.   To that end, you should be aware of the   1 warning sign we've spotted with Kennametal .  

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.

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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.