Is Allegion (NYSE:ALLE) using too much debt?
Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We can see that Allegation plc (NYSE:ALLE) uses debt in its operations. But does this debt worry shareholders?
When is debt a problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. 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 about a company’s use of debt, we first look at cash and debt together.
See our latest analysis for Allegion
What is Allegion’s net debt?
As you can see below, Allegion had $1.44 billion in debt, as of March 2022, which is about the same as the previous year. You can click on the graph for more details. However, he has $305.1 million in cash to offset this, resulting in a net debt of approximately $1.13 billion.
How healthy is Allegion’s balance sheet?
The latest balance sheet data shows Allegion had liabilities of $581.5 million due within the year, and liabilities of $1.68 billion due thereafter. On the other hand, it had $305.1 million in cash and $324.3 million in receivables within one year. It therefore has liabilities totaling $1.63 billion more than its cash and short-term receivables, combined.
Given that publicly traded Allegion shares are worth a total of US$9.78 billion, it seems unlikely that this level of liability is a major threat. But there are enough liabilities that we certainly recommend that shareholders continue to monitor the balance sheet in the future.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
We would say that Allegion’s moderate net debt to EBITDA ratio (1.9) indicates prudence in leverage. And its strong interest coverage of 10.7 times makes us even more comfortable. Unfortunately, Allegion has seen its EBIT drop by 4.8% over the last twelve months. If this earnings trend continues, its leverage will become heavy like the heart of a polar bear looking at its only cub. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Allegion’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Allegion has produced strong free cash flow equivalent to 80% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
Allegion’s conversion of EBIT to free cash flow suggests it can manage its debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. But, on a darker note, we are a bit concerned about its EBIT growth rate. Looking at all of the aforementioned factors together, it seems to us that Allegion can manage its debt quite comfortably. Of course, while this leverage can improve return on equity, it comes with more risk, so it’s worth keeping an eye out for. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. We have identified 2 warning signs with Allegion, and understanding them should be part of your investment process.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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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.