Does Canadian Pacific Railway (TSE:CP) Have A Healthy Balance Sheet?

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. Importantly, Canadian Pacific Railway Limited (TSE:CP) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Canadian Pacific Railway

How Much Debt Does Canadian Pacific Railway Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Canadian Pacific Railway had CA$19.7b of debt, an increase on CA$9.60b, over one year. Net debt is about the same, since the it doesn't have much cash.

A Look At Canadian Pacific Railway's Liabilities

Zooming in on the latest balance sheet data, we can see that Canadian Pacific Railway had liabilities of CA$3.19b due within 12 months and liabilities of CA$30.4b due beyond that. Offsetting these obligations, it had cash of CA$85.0m as well as receivables valued at CA$818.0m due within 12 months. So it has liabilities totalling CA$32.7b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Canadian Pacific Railway is worth a massive CA$83.5b, 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Canadian Pacific Railway has net debt to EBITDA of 4.5 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.2 suggests it can easily service that debt. Sadly, Canadian Pacific Railway's EBIT actually dropped 3.2% 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 ultimately the future profitability of the business will decide if Canadian Pacific Railway can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Canadian Pacific Railway's free cash flow amounted to 44% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Canadian Pacific Railway's net debt to EBITDA was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. We think that Canadian Pacific Railway'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. 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. For example Canadian Pacific Railway has 3 warning signs (and 1 which is significant) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.