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 can see that The Weir Group PLC (LON:WEIR) does use debt in its business. 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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Weir Group's Debt?
The chart below, which you can click on for greater detail, shows that Weir Group had UK£1.25b in debt in December 2020; about the same as the year before. However, it also had UK£351.7m in cash, and so its net debt is UK£895.0m.
A Look At Weir Group's Liabilities
Zooming in on the latest balance sheet data, we can see that Weir Group had liabilities of UK£646.4m due within 12 months and liabilities of UK£1.59b due beyond that. Offsetting these obligations, it had cash of UK£351.7m as well as receivables valued at UK£424.8m due within 12 months. So its liabilities total UK£1.46b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Weir Group is worth UK£4.77b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weir Group has a debt to EBITDA ratio of 2.5 and its EBIT covered its interest expense 5.9 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly Weir Group's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Weir Group 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Weir Group produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
When it comes to the balance sheet, the standout positive for Weir Group was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. For example, its net debt to EBITDA makes us a little nervous about its debt. Considering this range of data points, we think Weir Group is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For instance, we've identified 1 warning sign for Weir Group that you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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