Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Illinois Tool Works Inc. (NYSE:ITW) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Illinois Tool Works's Debt?
The chart below, which you can click on for greater detail, shows that Illinois Tool Works had US$8.47b in debt in June 2024; about the same as the year before. However, it does have US$862.0m in cash offsetting this, leading to net debt of about US$7.61b.
How Healthy Is Illinois Tool Works' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Illinois Tool Works had liabilities of US$4.80b due within 12 months and liabilities of US$7.81b due beyond that. On the other hand, it had cash of US$862.0m and US$3.25b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$8.50b.
Of course, Illinois Tool Works has a titanic market capitalization of US$76.0b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Illinois Tool Works's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its commanding EBIT of 18.4 times its interest expense, implies the debt load is as light as a peacock feather. The good news is that Illinois Tool Works has increased its EBIT by 7.1% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Illinois Tool Works 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Illinois Tool Works produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
The good news is that Illinois Tool Works's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And we also thought its conversion of EBIT to free cash flow was a positive. When we consider the range of factors above, it looks like Illinois Tool Works is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Illinois Tool Works has 1 warning sign we think you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.
