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. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that William Hill plc (LON:WMH) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is William Hill’s Net Debt?
As you can see below, at the end of July 2019, William Hill had UK£897.4m of debt, up from UK£721.4m a year ago. Click the image for more detail. On the flip side, it has UK£433.4m in cash leading to net debt of about UK£464.0m.
How Strong Is William Hill’s Balance Sheet?
The latest balance sheet data shows that William Hill had liabilities of UK£757.3m due within a year, and liabilities of UK£908.5m falling due after that. Offsetting these obligations, it had cash of UK£433.4m as well as receivables valued at UK£69.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£1.16b.
This deficit is considerable relative to its market capitalization of UK£1.64b, so it does suggest shareholders should keep an eye on William Hill’s use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
William Hill has net debt worth 2.0 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 4.3 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. Importantly, William Hill’s EBIT fell a jaw-dropping 64% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if William Hill 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, William Hill recorded free cash flow of 38% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
We’d go so far as to say William Hill’s EBIT growth rate was disappointing. But at least its net debt to EBITDA is not so bad. Overall, we think it’s fair to say that William Hill has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we’ve identified 3 warning signs for William Hill (1 is potentially serious) you should be aware of.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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