Is Worley (ASX:WOR) Using Too Much Debt?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Worley Limited (ASX:WOR) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Worley

What Is Worley's Debt?

As you can see below, at the end of December 2021, Worley had AU$1.95b of debt, up from AU$1.71b a year ago. Click the image for more detail. However, it also had AU$562.0m in cash, and so its net debt is AU$1.38b.

How Healthy Is Worley's Balance Sheet?

The latest balance sheet data shows that Worley had liabilities of AU$2.48b due within a year, and liabilities of AU$1.98b falling due after that. On the other hand, it had cash of AU$562.0m and AU$1.91b worth of receivables due within a year. So it has liabilities totalling AU$1.99b more than its cash and near-term receivables, combined.

Worley has a market capitalization of AU$7.37b, so it could very likely raise cash to ameliorate 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 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Worley's debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 6.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The bad news is that Worley saw its EBIT decline by 12% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Worley 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Worley actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

When it comes to the balance sheet, the standout positive for Worley was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. In particular, EBIT growth rate gives us cold feet. Looking at all this data makes us feel a little cautious about Worley's debt levels. 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. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Worley that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.