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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Orora Limited (ASX:ORA) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Orora
What Is Orora's Net Debt?
The image below, which you can click on for greater detail, shows that Orora had debt of AU$359.9m at the end of December 2020, a reduction from AU$1.08b over a year. However, because it has a cash reserve of AU$83.4m, its net debt is less, at about AU$276.5m.
A Look At Orora's Liabilities
Zooming in on the latest balance sheet data, we can see that Orora had liabilities of AU$755.1m due within 12 months and liabilities of AU$605.7m due beyond that. On the other hand, it had cash of AU$83.4m and AU$402.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$874.5m.
This deficit isn't so bad because Orora is worth AU$2.77b, and thus could probably raise enough capital to shore up 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.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Orora's low debt to EBITDA ratio of 0.88 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.7 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. And we also note warmly that Orora grew its EBIT by 13% last year, making its debt load easier to handle. 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 Orora 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 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. In the last three years, Orora's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Both Orora's ability to handle its debt, based on its EBITDA, and its EBIT growth rate gave us comfort that it can handle its debt. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think Orora is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example, we've discovered 3 warning signs for Orora that you should be aware of before investing here.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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. 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.
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About ASX:ORA
Orora
Designs, manufactures, and supplies packaging products and services to the grocery, fast moving consumer goods, and industrial markets in Australia, New Zealand, the United States, and internationally.
Second-rate dividend payer low.
