Western Forest Products (TSE:WEF) Has A Pretty Healthy Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Western Forest Products Inc. (TSE:WEF) does carry debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

View our latest analysis for Western Forest Products

What Is Western Forest Products's Net Debt?

As you can see below, Western Forest Products had CA$2.50m of debt at March 2021, down from CA$139.2m a year prior. But it also has CA$3.10m in cash to offset that, meaning it has CA$600.0k net cash.

How Healthy Is Western Forest Products' Balance Sheet?

We can see from the most recent balance sheet that Western Forest Products had liabilities of CA$119.6m falling due within a year, and liabilities of CA$151.2m due beyond that. Offsetting this, it had CA$3.10m in cash and CA$74.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$193.7m.

While this might seem like a lot, it is not so bad since Western Forest Products has a market capitalization of CA$739.6m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Western Forest Products also has more cash than debt, so we're pretty confident it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, Western Forest Products turned things around in the last 12 months, delivering and EBIT of CA$136m. 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 Western Forest Products's ability to maintain a healthy balance sheet going forward. 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. While Western Forest Products has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last year, Western Forest Products generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While Western Forest Products does have more liabilities than liquid assets, it also has net cash of CA$600.0k. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in CA$117m. So is Western Forest Products's debt a risk? It doesn't seem so to us. 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. We've identified 3 warning signs with Western Forest Products (at least 1 which is concerning) , and understanding them should be part of your investment process.

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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