Warren Buffett famously said, ‘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 can see that Brickworks Limited (ASX:BKW) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Brickworks Carry?
The chart below, which you can click on for greater detail, shows that Brickworks had AU$333.2m in debt in January 2019; about the same as the year before. However, it also had AU$87.6m in cash, and so its net debt is AU$245.6m.
A Look At Brickworks’s Liabilities
The latest balance sheet data shows that Brickworks had liabilities of AU$411.1m due within a year, and liabilities of AU$459.2m falling due after that. On the other hand, it had cash of AU$87.6m and AU$111.9m worth of receivables due within a year. So it has liabilities totalling AU$670.9m more than its cash and near-term receivables, combined.
Brickworks has a market capitalization of AU$2.55b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
Brickworks has net debt worth 2.3 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 4.0 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. It is well worth noting that Brickworks’s EBIT shot up like bamboo after rain, gaining 41% in the last twelve months. That’ll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Brickworks 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Brickworks 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.
Happily, Brickworks’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its interest cover does undermine this impression a bit. When we consider the range of factors above, it looks like Brickworks is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. We’d be motivated to research the stock further if we found out that Brickworks 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.
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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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. Thank you for reading.