Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 note that Yancoal Australia Ltd (ASX:YAL) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Yancoal Australia’s Debt?
The image below, which you can click on for greater detail, shows that Yancoal Australia had debt of AU$4.12b at the end of December 2018, a reduction from AU$4.72b over a year. However, it also had AU$1.03b in cash, and so its net debt is AU$3.09b.
A Look At Yancoal Australia’s Liabilities
Zooming in on the latest balance sheet data, we can see that Yancoal Australia had liabilities of AU$913.0m due within 12 months and liabilities of AU$5.66b due beyond that. Offsetting these obligations, it had cash of AU$1.03b as well as receivables valued at AU$587.0m due within 12 months. So its liabilities total AU$4.95b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s AU$4.50b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.
Yancoal Australia has net debt worth 1.7 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 4.7 times the interest expense. While that doesn’t worry us too much, it does suggest the interest payments are somewhat of a burden. Notably, Yancoal Australia’s EBIT launched higher than Elon Musk, gaining a whopping 281% on last year. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Yancoal Australia’s ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Yancoal Australia actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Both Yancoal Australia’s ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. Considering this range of data points, we think Yancoal Australia is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Yancoal Australia insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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