Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Quaker Chemical Corporation (NYSE:KWR) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Quaker Chemical’s Debt?
As you can see below, at the end of March 2020, Quaker Chemical had US$1.12b of debt, up from US$12.4m a year ago. Click the image for more detail. On the flip side, it has US$316.4m in cash leading to net debt of about US$803.6m.
How Strong Is Quaker Chemical’s Balance Sheet?
The latest balance sheet data shows that Quaker Chemical had liabilities of US$340.6m due within a year, and liabilities of US$1.42b falling due after that. Offsetting this, it had US$316.4m in cash and US$357.9m in receivables that were due within 12 months. So it has liabilities totalling US$1.1b more than its cash and near-term receivables, combined.
Quaker Chemical has a market capitalization of US$3.54b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Quaker Chemical has a debt to EBITDA ratio of 4.8 and its EBIT covered its interest expense 4.3 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Fortunately, Quaker Chemical grew its EBIT by 5.6% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Quaker Chemical’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Quaker Chemical recorded free cash flow worth 66% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Quaker Chemical’s net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we thought its conversion of EBIT to free cash flow was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about Quaker Chemical’s use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example – Quaker Chemical has 4 warning signs (and 1 which doesn’t sit too well with us) we think you should know about.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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