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David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ 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. As with many other companies. Qantas Airways Limited (ASX:QAN) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Qantas Airways Carry?
The chart below, which you can click on for greater detail, shows that Qantas Airways had AU$5.01b in debt in December 2018; about the same as the year before. On the flip side, it has AU$1.49b in cash leading to net debt of about AU$3.52b.
How Strong Is Qantas Airways’s Balance Sheet?
The latest balance sheet data shows that Qantas Airways had liabilities of AU$7.89b due within a year, and liabilities of AU$7.35b falling due after that. On the other hand, it had cash of AU$1.49b and AU$953.0m worth of receivables due within a year. So its liabilities total AU$12.8b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the AU$8.35b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Qantas Airways would probably need a major re-capitalization if its creditors were to demand repayment. Because it carries more debt than cash, we think it’s worth watching Qantas Airways’s balance sheet over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt sitting at just 1.22 times EBITDA, Qantas Airways is arguably pretty conservatively geared. And it boasts interest cover of 8.84 times, which is more than adequate. On the other hand, Qantas Airways saw its EBIT drop by 9.6% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Qantas Airways’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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Qantas Airways 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.
Qantas Airways’s level of total liabilities and EBIT growth rate definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Qantas Airways’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. Given our hesitation about the stock, it would be good to know if Qantas Airways insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.