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’. So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that Domtar Corporation (NYSE:UFS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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, 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.
What Is Domtar’s Debt?
The image below, which you can click on for greater detail, shows that at December 2019 Domtar had debt of US$938.0m, up from US$843.0m in one year. However, it does have US$61.0m in cash offsetting this, leading to net debt of about US$877.0m.
How Strong Is Domtar’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Domtar had liabilities of US$766.0m due within 12 months and liabilities of US$1.76b due beyond that. Offsetting this, it had US$61.0m in cash and US$638.0m in receivables that were due within 12 months. So its liabilities total US$1.83b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$1.11b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt. After all, Domtar would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Domtar has net debt worth 1.6 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 4.9 times the interest expense. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Importantly, Domtar’s EBIT fell a jaw-dropping 41% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Domtar 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 it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Domtar generated free cash flow amounting to a very robust 91% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
On the face of it, Domtar’s EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Domtar’s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. Be aware that Domtar is showing 4 warning signs in our investment analysis , you should know about…
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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