Warren Buffett said: “Volatility is far from synonymous with risk. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We note that MDC Holdings, Inc. (NYSE:MDC) has debt on its balance sheet. But the more important question is: what risk does this debt create?
Why is debt risky?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
See our latest analysis for MDC Holdings
How much debt does MDC Holdings have?
The image below, which you can click on for more details, shows that as of December 2021, MDC Holdings had $1.75 billion in debt, up from $1.25 billion in one year. On the other hand, it has $485.8 million in cash, resulting in a net debt of around $1.26 billion.
How healthy is MDC Holdings’ balance sheet?
The latest balance sheet data shows that MDC Holdings had liabilities of $847.9 million due within one year, and liabilities of $1.52 billion due thereafter. In return, it had $485.8 million in cash and $98.6 million in receivables due within 12 months. It therefore has liabilities totaling $1.78 billion more than its cash and short-term receivables, combined.
This shortfall is sizable relative to its market capitalization of US$2.72 billion, so it suggests shareholders should monitor MDC Holdings’ use of debt. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
MDC Holdings’ net debt to EBITDA ratio of around 1.6 suggests only moderate debt usage. And its strong interest coverage of 1k times, makes us even more comfortable. On top of that, we are pleased to report that MDC Holdings increased its EBIT by 69%, reducing the specter of future debt repayments. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine MDC Holdings’ ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, while the taxman may love accounting profits, lenders only accept cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, MDC Holdings has had negative free cash flow, overall. Debt is generally more expensive and almost always riskier in the hands of a company with negative free cash flow. Shareholders should hope for an improvement.
Our point of view
MDC Holdings’ ability to cover its interest expense with its EBIT and its rate of EBIT growth has given us comfort in its ability to manage its debt. In contrast, our confidence was shaken by its apparent struggle to convert EBIT to free cash flow. When we consider all the factors mentioned above, we feel a bit cautious about MDC Holdings’ use of debt. While debt has its upside in higher potential returns, we think shareholders should certainly consider how debt levels could make the stock more risky. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. To do this, you need to find out about the 4 warning signs we spotted with MDC Holdings (including 2 must-haves).
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.