Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Donaldson Company, Inc. (NYSE:DCI) does carry debt. But should shareholders be worried about its use of debt?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Donaldson Company's Debt?

As you can see below, Donaldson Company had US$556.2m of debt at April 2024, down from US$622.1m a year prior. However, it also had US$223.7m in cash, and so its net debt is US$332.5m.

How Strong Is Donaldson Company's Balance Sheet?

We can see from the most recent balance sheet that Donaldson Company had liabilities of US$735.2m falling due within a year, and liabilities of US$646.9m due beyond that. Offsetting these obligations, it had cash of US$223.7m as well as receivables valued at US$653.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$505.2m.

Of course, Donaldson Company has a market capitalization of US$9.01b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Donaldson Company has a low net debt to EBITDA ratio of only 0.52. And its EBIT covers its interest expense a whopping 25.7 times over. So we're pretty relaxed about its super-conservative use of debt. Also good is that Donaldson Company grew its EBIT at 10% over the last year, further increasing its ability to manage debt. 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 Donaldson Company 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.

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, Donaldson Company produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Donaldson Company's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Looking at the bigger picture, we think Donaldson Company's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Donaldson Company insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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.

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