Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We note that 3M Company (NYSE:MMM) has debt on its balance sheet. But should shareholders worry about its use of debt?
When is debt dangerous?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth, without any negative consequences. When we look at debt levels, we first consider cash and debt levels, together.
See our latest analysis for 3M
What is 3M Debt?
You can click on the chart below for historical numbers, but it shows 3M had $16.7 billion in debt in March 2022, up from $18.2 billion a year prior. However, he also had $3.36 billion in cash, so his net debt is $13.4 billion.
How healthy is 3M’s balance sheet?
Zooming in on the latest balance sheet data, we can see that 3M had liabilities of US$9.15 billion due within 12 months and liabilities of US$21.7 billion due beyond. In compensation for these obligations, it had cash of 3.36 billion US dollars as well as receivables valued at 4.82 billion US dollars due within 12 months. It therefore has liabilities totaling $22.7 billion more than its cash and short-term receivables, combined.
While that might sound like a lot, it’s not too bad since 3M has a huge market capitalization of US$74.0 billion, so it could probably bolster its balance sheet by raising capital if needed. 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). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
3M has a low net debt to EBITDA ratio of just 1.4. And its EBIT covers its interest charges 17.2 times. So we’re pretty relaxed about his super-conservative use of debt. Although 3M doesn’t seem to have gained much on the EBIT line, at least earnings are holding steady for now. When analyzing debt levels, the balance sheet is the obvious starting point. But future earnings, more than anything, will determine 3M’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, 3M has produced strong free cash flow equivalent to 79% 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
3M’s interest cover suggests it can manage its debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. And this is only the beginning of good news since its conversion of EBIT into free cash flow is also very pleasing. When we consider the range of factors above, it seems that 3M is quite sensible with its use of debt. This means they take on a bit more risk, hoping to increase shareholder returns. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. To this end, you should be aware of the 1 warning sign we spotted with 3M.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-flowing growth stocks without further ado.
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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.