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. We note that Vestis Corporation (NYSE:VSTS) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Vestis's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2024 Vestis had US$1.40b of debt, an increase on none, over one year. However, it also had US$29.1m in cash, and so its net debt is US$1.37b.
How Healthy Is Vestis' Balance Sheet?
According to the last reported balance sheet, Vestis had liabilities of US$429.8m due within 12 months, and liabilities of US$1.81b due beyond 12 months. On the other hand, it had cash of US$29.1m and US$409.9m worth of receivables due within a year. So its liabilities total US$1.81b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of US$1.96b, so it does suggest shareholders should keep an eye on Vestis' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). 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).
While we wouldn't worry about Vestis's net debt to EBITDA ratio of 4.1, we think its super-low interest cover of 2.0 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Fortunately, Vestis grew its EBIT by 6.7% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Vestis's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Vestis recorded free cash flow worth a fulsome 93% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Our View
Neither Vestis's ability to cover its interest expense with its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We think that Vestis's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. To that end, you should learn about the 2 warning signs we've spotted with Vestis (including 1 which shouldn't be ignored) .
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.