The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Prestige Consumer Healthcare Inc. (NYSE:PBH) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Prestige Consumer Healthcare Carry?
You can click the graphic below for the historical numbers, but it shows that Prestige Consumer Healthcare had US$1.20b of debt in December 2023, down from US$1.42b, one year before. On the flip side, it has US$63.6m in cash leading to net debt of about US$1.14b.
How Strong Is Prestige Consumer Healthcare's Balance Sheet?
According to the last reported balance sheet, Prestige Consumer Healthcare had liabilities of US$127.4m due within 12 months, and liabilities of US$1.61b due beyond 12 months. On the other hand, it had cash of US$63.6m and US$174.3m worth of receivables due within a year. So it has liabilities totalling US$1.50b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Prestige Consumer Healthcare has a market capitalization of US$3.46b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
Prestige Consumer Healthcare has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 4.9 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We saw Prestige Consumer Healthcare grow its EBIT by 2.1% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 Prestige Consumer Healthcare 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Prestige Consumer Healthcare produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
On our analysis Prestige Consumer Healthcare's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its net debt to EBITDA makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Prestige Consumer Healthcare's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Prestige Consumer Healthcare you should know about.
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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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.