Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Wilson Sons Limited (BVMF:WSON33) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Wilson Sons's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Wilson Sons had US$331.6m of debt, an increase on US$313.3m, over one year. However, it also had US$112.6m in cash, and so its net debt is US$219.0m.
How Healthy Is Wilson Sons' Balance Sheet?
According to the last reported balance sheet, Wilson Sons had liabilities of US$117.2m due within 12 months, and liabilities of US$474.8m due beyond 12 months. Offsetting this, it had US$112.6m in cash and US$61.1m in receivables that were due within 12 months. So its liabilities total US$418.3m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of US$569.6m, so it does suggest shareholders should keep an eye on Wilson Sons' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
Wilson Sons's net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 5.4 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Sadly, Wilson Sons's EBIT actually dropped 3.8% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Wilson Sons will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
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, Wilson Sons produced sturdy free cash flow equating to 54% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Both Wilson Sons's level of total liabilities and its EBIT growth rate were discouraging. But its not so bad at converting EBIT to free cash flow. We should also note that Infrastructure industry companies like Wilson Sons commonly do use debt without problems. We think that Wilson Sons's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 5 warning signs for Wilson Sons (1 is a bit unpleasant) you should be aware of.
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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