Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 can see that Worthington Industries, Inc. (NYSE:WOR) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Worthington Industries’s Net Debt?
The image below, which you can click on for greater detail, shows that at November 2019 Worthington Industries had debt of US$698.8m, up from US$750 in one year. However, because it has a cash reserve of US$72.3m, its net debt is less, at about US$626.5m.
A Look At Worthington Industries’s Liabilities
Zooming in on the latest balance sheet data, we can see that Worthington Industries had liabilities of US$473.9m due within 12 months and liabilities of US$976.4m due beyond that. Offsetting this, it had US$72.3m in cash and US$497.3m in receivables that were due within 12 months. So it has liabilities totalling US$880.7m more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Worthington Industries is worth US$2.10b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
Worthington Industries’s debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Worse, Worthington Industries’s EBIT was down 41% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Worthington Industries’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Worthington Industries actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Neither Worthington Industries’s ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that Worthington Industries is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. For example, we’ve discovered 4 warning signs for Worthington Industries that you should be aware of before investing here.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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