Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” So it can be obvious that you need to factor in debt, when you think about how risky a given stock is, because too much debt can sink a business. We notice that Textron Inc. (NYSE: TXT) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
Why is debt risky?
Debt and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is where a company has to issue shares at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is Textron’s debt?
You can click on the chart below for historical numbers, but it shows Textron had $ 4.09 billion in debt in April 2021, up from $ 5.03 billion a year earlier. However, because it has a cash reserve of US $ 1.90 billion, its net debt is lower, at around US $ 2.20 billion.
How healthy is Textron’s track record?
According to the latest published balance sheet, Textron had a liability of US $ 3.12 billion due within 12 months and a liability of US $ 6.30 billion due beyond 12 months. In return, he had US $ 1.90 billion in cash and US $ 883.0 million in receivables due within 12 months. Its liabilities are therefore $ 6.64 billion more than the combination of its cash and short-term receivables.
This deficit is not that bad as Textron is worth US $ 15.1 billion, and could therefore probably raise enough capital to consolidate its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky.
We measure a company’s indebtedness relative to its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) covers its interest costs (interest coverage). In this way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Textron’s net debt stands at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense only 4.8 times last year. While these numbers do not alarm us, it should be noted that the cost of the company’s debt does have a real impact. Shareholders should know that Textron’s EBIT fell 33% last year. If this earnings trend continues, paying off debt will be about as easy as raising cats on a roller coaster. The balance sheet is clearly the area to focus on when analyzing debt. But it is future profits, more than anything, that will determine Textron’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future you can check out this free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits do not reduce it. We must therefore clearly consider whether this EBIT leads to a corresponding free cash flow. Over the past three years, Textron has produced strong free cash flow equivalent to 74% of its EBIT, which we expected. This free cash flow puts the business in a good position to pay off debt, if any.
Our point of view
Textron’s struggle to increase its EBIT made us question the strength of its balance sheet, but the other data points we considered were relatively profitable. For example, his conversion from EBIT to free cash flow was refreshing. In view of all the angles mentioned above, it seems to us that Textron is a somewhat risky investment because of its debt. Not all risks are bad, as they can increase stock returns if they pay off, but this risk of leverage is worth considering. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist off the balance sheet. Note that Textron shows 4 warning signs in our investment analysis , you should know …
If, after all of this, you’re more interested in a fast-growing company with a rock-solid balance sheet, then take a quick look at our list of cash-growing stocks.
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