Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Parker-Hannifin Corporation (NYSE:PH) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Parker-Hannifin's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Parker-Hannifin had US$10.2b of debt in September 2024, down from US$12.2b, one year before. On the flip side, it has US$371.1m in cash leading to net debt of about US$9.82b.
How Healthy Is Parker-Hannifin's Balance Sheet?
We can see from the most recent balance sheet that Parker-Hannifin had liabilities of US$7.34b falling due within a year, and liabilities of US$9.36b due beyond that. Offsetting this, it had US$371.1m in cash and US$3.18b in receivables that were due within 12 months. So it has liabilities totalling US$13.1b more than its cash and near-term receivables, combined.
Given Parker-Hannifin has a humongous market capitalization of US$91.2b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
Parker-Hannifin's net debt of 2.0 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.6 times its interest expenses harmonizes with that theme. Parker-Hannifin grew its EBIT by 7.2% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Parker-Hannifin's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Parker-Hannifin produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
Happily, Parker-Hannifin's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its interest cover also supports that impression! Taking all this data into account, it seems to us that Parker-Hannifin takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Parker-Hannifin that you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.
