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. So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Quaker Chemical Corporation (NYSE:KWR) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Quaker Chemical’s Debt?
As you can see below, at the end of September 2019, Quaker Chemical had US$863.0m of debt, up from US$52.5m a year ago. Click the image for more detail. On the flip side, it has US$128.2m in cash leading to net debt of about US$734.9m.
A Look At Quaker Chemical’s Liabilities
Zooming in on the latest balance sheet data, we can see that Quaker Chemical had liabilities of US$345.8m due within 12 months and liabilities of US$1.18b due beyond that. Offsetting these obligations, it had cash of US$128.2m as well as receivables valued at US$370.7m due within 12 months. So its liabilities total US$1.02b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Quaker Chemical is worth US$3.01b, 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
As it happens Quaker Chemical has a fairly concerning net debt to EBITDA ratio of 5.5 but very strong interest coverage of 12.5. So either it has access to very cheap long term debt or that interest expense is going to grow! Quaker Chemical grew its EBIT by 3.7% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 Quaker Chemical can strengthen its balance sheet over time. 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. Over the most recent three years, Quaker Chemical recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On our analysis Quaker Chemical’s interest cover should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. To be specific, it seems about as good at managing its debt, based on its EBITDA, as wet socks are at keeping your feet warm. 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. 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. Be aware that Quaker Chemical is showing 4 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable…
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.