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. We note that West Fraser Timber Co. Ltd. (TSE:WFG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
What Is West Fraser Timber's Net Debt?
The image below, which you can click on for greater detail, shows that West Fraser Timber had debt of US$499.0m at the end of June 2021, a reduction from US$771.9m over a year. However, it does have US$2.23b in cash offsetting this, leading to net cash of US$1.73b.
How Healthy Is West Fraser Timber's Balance Sheet?
We can see from the most recent balance sheet that West Fraser Timber had liabilities of US$1.28b falling due within a year, and liabilities of US$1.60b due beyond that. Offsetting this, it had US$2.23b in cash and US$799.0m in receivables that were due within 12 months. So it can boast US$158.0m more liquid assets than total liabilities.
Having regard to West Fraser Timber's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$8.71b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that West Fraser Timber has more cash than debt is arguably a good indication that it can manage its debt safely.
Better yet, West Fraser Timber grew its EBIT by 54,330% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if West Fraser Timber 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. West Fraser Timber may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, West Fraser Timber produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to investigate a company's debt, in this case West Fraser Timber has US$1.73b in net cash and a decent-looking balance sheet. And we liked the look of last year's 54,330% year-on-year EBIT growth. So we don't think West Fraser Timber's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with West Fraser Timber .
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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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West Fraser Timber
West Fraser Timber Co. Ltd., a diversified wood products company, engages in manufacturing, selling, marketing, and distributing lumber, engineered wood products, pulp, newsprint, wood chips, and other residuals and renewable energy.
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