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.’ 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 United States Cellular Corporation (NYSE:USM) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is United States Cellular’s Net Debt?
The chart below, which you can click on for greater detail, shows that United States Cellular had US$1.63b in debt in June 2020; about the same as the year before. However, it does have US$418.0m in cash offsetting this, leading to net debt of about US$1.21b.
How Strong Is United States Cellular’s Balance Sheet?
The latest balance sheet data shows that United States Cellular had liabilities of US$697.0m due within a year, and liabilities of US$3.46b falling due after that. On the other hand, it had cash of US$418.0m and US$1.08b worth of receivables due within a year. So it has liabilities totalling US$2.7b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$2.98b. This suggests shareholders would be 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Given net debt is only 1.4 times EBITDA, it is initially surprising to see that United States Cellular’s EBIT has low interest coverage of 1.6 times. So one way or the other, it’s clear the debt levels are not trivial. Importantly United States Cellular’s EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. 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 United States Cellular 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, United States Cellular recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
On the face of it, United States Cellular’s conversion of EBIT to free cash flow left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at managing its debt, based on its EBITDA,; that’s encouraging. Looking at the bigger picture, it seems clear to us that United States Cellular’s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Like risks, for instance. Every company has them, and we’ve spotted 2 warning signs for United States Cellular (of which 1 is concerning!) you should know about.
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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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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