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. As with many other companies Fastenal Company (NASDAQ:FAST) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.

What Is Fastenal’s Debt?

The image below, which you can click on for greater detail, shows that at June 2019 Fastenal had debt of US$500.0m, up from US$425.0m in one year. On the flip side, it has US$175.0m in cash leading to net debt of about US$325.0m.

NasdaqGS:FAST Historical Debt, August 19th 2019
NasdaqGS:FAST Historical Debt, August 19th 2019

How Strong Is Fastenal’s Balance Sheet?

We can see from the most recent balance sheet that Fastenal had liabilities of US$527.9m falling due within a year, and liabilities of US$724.8m due beyond that. Offsetting these obligations, it had cash of US$175.0m as well as receivables valued at US$819.8m due within 12 months. So it has liabilities totalling US$257.9m more than its cash and near-term receivables, combined.

This state of affairs indicates that Fastenal’s balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it’s very unlikely that the US$17.2b company is short on cash, but still worth keeping an eye on the balance sheet.

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.

Fastenal’s net debt is only 0.28 times its EBITDA. And its EBIT easily covers its interest expense, being 73.6 times the size. So we’re pretty relaxed about its super-conservative use of debt. And we also note warmly that Fastenal grew its EBIT by 10% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Fastenal can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Fastenal’s free cash flow amounted to 48% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.