Here's Why Canadian Pacific Railway (TSE:CP) Has A Meaningful Debt Burden

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Canadian Pacific Railway Limited (TSE:CP) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Canadian Pacific Railway

How Much Debt Does Canadian Pacific Railway Carry?

As you can see below, at the end of June 2022, Canadian Pacific Railway had CA$20.1b of debt, up from CA$8.80b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Canadian Pacific Railway's Balance Sheet?

The latest balance sheet data shows that Canadian Pacific Railway had liabilities of CA$3.21b due within a year, and liabilities of CA$31.3b falling due after that. Offsetting this, it had CA$154.0m in cash and CA$962.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$33.3b.

While this might seem like a lot, it is not so bad since Canadian Pacific Railway has a huge market capitalization of CA$91.4b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Canadian Pacific Railway's debt is 4.6 times its EBITDA, and its EBIT cover its interest expense 6.4 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Sadly, Canadian Pacific Railway's EBIT actually dropped 8.0% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Canadian Pacific Railway'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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Canadian Pacific Railway recorded free cash flow of 44% of its EBIT, which is weaker 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. For example, its interest cover is relatively strong. When we consider all the factors discussed, it seems to us that Canadian Pacific Railway is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Canadian Pacific Railway you should be aware of, and 1 of them shouldn't be ignored.

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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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.