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. Importantly, Kronos Worldwide, Inc. (NYSE:KRO) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Kronos Worldwide Carry?
As you can see below, Kronos Worldwide had US$436.1m of debt at September 2019, down from US$465.9m a year prior. On the flip side, it has US$385.8m in cash leading to net debt of about US$50.3m.
How Healthy Is Kronos Worldwide’s Balance Sheet?
We can see from the most recent balance sheet that Kronos Worldwide had liabilities of US$227.5m falling due within a year, and liabilities of US$810.5m due beyond that. On the other hand, it had cash of US$385.8m and US$348.3m worth of receivables due within a year. So it has liabilities totalling US$303.9m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Kronos Worldwide has a market capitalization of US$1.33b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Kronos Worldwide has a low net debt to EBITDA ratio of only 0.26. And its EBIT easily covers its interest expense, being 12.3 times the size. So we’re pretty relaxed about its super-conservative use of debt. In fact Kronos Worldwide’s saving grace is its low debt levels, because its EBIT has tanked 62% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Kronos Worldwide 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Kronos Worldwide recorded free cash flow worth 55% 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.
Kronos Worldwide’s EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There’s no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Kronos Worldwide’s debt levels. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We’ve spotted 3 warning signs for Kronos Worldwide 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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