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. 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 note that Whitehaven Coal Limited (ASX:WHC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Whitehaven Coal's Debt?
The image below, which you can click on for greater detail, shows that Whitehaven Coal had debt of AU$173.9m at the end of June 2019, a reduction from AU$588.3m over a year. However, it does have AU$119.5m in cash offsetting this, leading to net debt of about AU$54.3m.
How Strong Is Whitehaven Coal's Balance Sheet?
According to the last reported balance sheet, Whitehaven Coal had liabilities of AU$339.1m due within 12 months, and liabilities of AU$983.8m due beyond 12 months. On the other hand, it had cash of AU$119.5m and AU$155.7m worth of receivables due within a year. So its liabilities total AU$1.05b more than the combination of its cash and short-term receivables.
Whitehaven Coal has a market capitalization of AU$3.12b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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.
With debt at a measly 0.038 times EBITDA and EBIT covering interest a whopping 31.4 times, it's clear that Whitehaven Coal is not a desperate borrower. So relative to past earnings, the debt load seems trivial. While Whitehaven Coal doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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 Whitehaven Coal 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Whitehaven Coal generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
The good news is that Whitehaven Coal's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like Whitehaven Coal is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We'd be motivated to research the stock further if we found out that Whitehaven Coal insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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