The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, The Clorox Company (NYSE:CLX) does carry debt. But the more important question is: how much risk is that debt creating?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Clorox
The chart below, which you can click on for greater detail, shows that Clorox had US$2.71b in debt in June 2022; about the same as the year before. However, it also had US$183.0m in cash, and so its net debt is US$2.53b.
Zooming in on the latest balance sheet data, we can see that Clorox had liabilities of US$1.78b due within 12 months and liabilities of US$3.65b due beyond that. Offsetting these obligations, it had cash of US$183.0m as well as receivables valued at US$681.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.57b.
Clorox has a very large market capitalization of US$16.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
With net debt to EBITDA of 2.7 Clorox has a fairly noticeable amount of debt. But the high interest coverage of 7.2 suggests it can easily service that debt. Importantly, Clorox's EBIT fell a jaw-dropping 40% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Clorox'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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Clorox recorded free cash flow worth a fulsome 87% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Clorox's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its conversion of EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Clorox's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. We've identified 3 warning signs with Clorox (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.
Find out whether Clorox is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
Simply Wall St's Editorial Team provides unbiased, factual reporting on global stocks using in-depth fundamental analysis.
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The Clorox Company manufactures and markets consumer and professional products worldwide.
The Snowflake is a visual investment summary with the score of each axis being calculated by 6 checks in 5 areas.
Read more about these checks in the individual report sections or in our analysis model.
Mediocre balance sheet second-rate dividend payer.
Simply Wall St's Editorial Team provides unbiased, factual reporting on global stocks using in-depth fundamental analysis.
Find out more about our editorial guidelines and team.
The Clorox Company manufactures and markets consumer and professional products worldwide.
The Snowflake is a visual investment summary with the score of each axis being calculated by 6 checks in 5 areas.
Read more about these checks in the individual report sections or in our analysis model.
Mediocre balance sheet second-rate dividend payer.
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