Warren Buffett famously said, 'Volatility is far from synonymous with risk.'  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.  We note that 3M Company (NYSE:MMM) does have debt on its balance sheet.  But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price.  Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing.  However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders.  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 3M's Net Debt?

The image below, which you can click on for greater detail, shows that 3M had debt of US$13.2b at the end of June 2024, a reduction from US$16.1b over a year.    However, it does have US$10.3b in cash offsetting this, leading to net debt of about US$2.84b.  

NYSE:MMM Debt to Equity History August 17th 2024

A Look At 3M's Liabilities

The latest balance sheet data shows that 3M had liabilities of US$14.3b due within a year, and liabilities of US$25.0b falling due after that.   On the other hand, it had cash of US$10.3b and US$3.58b worth of receivables due within a year.   So its liabilities outweigh the sum of its cash and (near-term) receivables by US$25.5b.  

This deficit isn't so bad because 3M is worth  a massive  US$69.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose.  But it's clear that we should definitely closely examine whether it can manage its debt without dilution.  

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).  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).

While 3M's low debt to EBITDA ratio of 0.39 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.0 times last year does give us pause.  So we'd recommend keeping a close eye on the impact financing costs are having on the business.        Unfortunately, 3M's EBIT flopped 17% over the last four quarters.  If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant.      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 3M 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 it's worth checking how much of that EBIT is backed by free cash flow.    Over the most recent three years, 3M recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax.  This cold hard cash means it can reduce its debt when it wants to.  

Our View

3M's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better.   There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash.       When we consider all the factors mentioned above, we do feel a bit cautious about 3M's use of debt.  While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase.    There's no doubt that we learn most about debt from the balance sheet.  However, not all investment risk resides within the balance sheet - far from it.   For example, we've discovered 3 warning signs for 3M that you should be aware of before investing here.  

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.