These 4 Measures Indicate That ESCO Technologies (NYSE:ESE) Is Using Debt Reasonably Well

Simply Wall St · 10/16 15:39

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that ESCO Technologies Inc. (NYSE:ESE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for ESCO Technologies

What Is ESCO Technologies's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 ESCO Technologies had US$173.0m of debt, an increase on US$148.0m, over one year. However, it also had US$63.0m in cash, and so its net debt is US$110.0m.

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NYSE:ESE Debt to Equity History October 16th 2024

A Look At ESCO Technologies' Liabilities

The latest balance sheet data shows that ESCO Technologies had liabilities of US$311.2m due within a year, and liabilities of US$306.2m falling due after that. Offsetting this, it had US$63.0m in cash and US$348.2m in receivables that were due within 12 months. So it has liabilities totalling US$206.1m more than its cash and near-term receivables, combined.

Of course, ESCO Technologies has a market capitalization of US$3.22b, 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.

ESCO Technologies's net debt is only 0.57 times its EBITDA. And its EBIT easily covers its interest expense, being 12.0 times the size. So we're pretty relaxed about its super-conservative use of debt. Fortunately, ESCO Technologies grew its EBIT by 8.6% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine ESCO Technologies'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, ESCO Technologies recorded free cash flow worth 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, ESCO Technologies's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Taking all this data into account, it seems to us that ESCO Technologies takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - ESCO Technologies has 1 warning sign we think you should be aware of.

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.