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.' 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 MSC Industrial Direct Co., Inc. (NYSE:MSM) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is MSC Industrial Direct's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 MSC Industrial Direct had debt of US$505.4m, up from US$463.9m in one year. However, because it has a cash reserve of US$25.9m, its net debt is less, at about US$479.5m.

A Look At MSC Industrial Direct's Liabilities

The latest balance sheet data shows that MSC Industrial Direct had liabilities of US$583.5m due within a year, and liabilities of US$470.1m falling due after that. On the other hand, it had cash of US$25.9m and US$419.8m worth of receivables due within a year. So its liabilities total US$607.8m more than the combination of its cash and short-term receivables.

Since publicly traded MSC Industrial Direct shares are worth a total of US$4.62b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

MSC Industrial Direct has a low net debt to EBITDA ratio of only 0.94. And its EBIT easily covers its interest expense, being 18.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, MSC Industrial Direct's EBIT dived 15%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 MSC Industrial Direct 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, MSC Industrial Direct produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, MSC Industrial Direct's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its EBIT growth rate has the opposite effect. Looking at all the aforementioned factors together, it strikes us that MSC Industrial Direct can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that MSC Industrial Direct insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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.