Here's Why Allegion (NYSE:ALLE) Can Manage Its Debt Responsibly

Allegion PLC +0.86%

Allegion PLC

ALLE

122.60

+0.86%

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that Allegion plc (NYSE:ALLE) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Allegion

What Is Allegion's Debt?

You can click the graphic below for the historical numbers, but it shows that Allegion had US$2.02b of debt in September 2023, down from US$2.23b, one year before. However, because it has a cash reserve of US$364.3m, its net debt is less, at about US$1.65b.

debt-equity-history-analysis
NYSE:ALLE Debt to Equity History January 30th 2024

How Healthy Is Allegion's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Allegion had liabilities of US$649.8m due within 12 months and liabilities of US$2.30b due beyond that. On the other hand, it had cash of US$364.3m and US$439.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.15b.

Since publicly traded Allegion shares are worth a very impressive total of US$11.0b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

With a debt to EBITDA ratio of 2.0, Allegion uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.1 times interest expense) certainly does not do anything to dispel this impression. We note that Allegion grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. 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 Allegion 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. During the last three years, Allegion produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Allegion's impressive EBIT growth rate implies it has the upper hand on its debt. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Zooming out, Allegion seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. Case in point: We've spotted 2 warning signs for Allegion 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.

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