Here’s why Illinois Tool Works (NYSE:ITW) can manage its debt responsibly
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 synonymous with risk.” 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 Illinois Tool Works Inc. (NYSE:ITW) has debt on its balance sheet. But does this debt worry shareholders?
What risk does debt carry?
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. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up 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 look at debt levels, we first consider cash and debt levels, together.
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How much debt does Illinois Tool Works have?
As you can see below, Illinois Tool Works had $7.64 billion in debt as of June 2022, about the same as the previous year. You can click on the graph for more details. However, he also had $879.0 million in cash, so his net debt is $6.76 billion.
How strong is Illinois Tool Works’ balance sheet?
We can see from the most recent balance sheet that Illinois Tool Works had liabilities of $4.29 billion due in one year and liabilities of $7.99 billion beyond. In return, it had $879.0 million in cash and $3.11 billion in receivables due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by $8.30 billion.
Of course, Illinois Tool Works has a titanic market capitalization of US$58.0 billion, so those liabilities are probably manageable. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time.
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 ).
We would say that Illinois Tool Works’ moderate net debt to EBITDA ratio (1.7) indicates prudence in leverage. And its towering EBIT of 19.5 times its interest expense means that the debt burden is as light as a peacock feather. It is important to note that Illinois Tool Works’ EBIT has remained essentially flat over the past twelve months. Ideally, it can reduce its debt by reviving its earnings growth. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether 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 analyst earnings forecast report interesting.
Finally, a company can only repay its debts with cold hard cash, not with book profits. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Illinois Tool Works has had free cash flow of 71% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
The good news is that Illinois Tool Works’ demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. And the good news doesn’t stop there, since its conversion of EBIT into free cash flow also confirms this impression! When we consider the range of factors above, it seems that Illinois Tool Works is quite sensitive with its use of debt. This means they take on a bit more risk, hoping to increase shareholder returns. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. To this end, you should be aware of the 1 warning sign we spotted with Illinois Tool Works.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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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.
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