These 4 Measures Indicate That British American Tobacco (LON:BATS) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies British American Tobacco p.l.c. (LON:BATS) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for British American Tobacco

How Much Debt Does British American Tobacco Carry?

The image below, which you can click on for greater detail, shows that British American Tobacco had debt of UK£42.2b at the end of June 2023, a reduction from UK£44.9b over a year. However, because it has a cash reserve of UK£4.13b, its net debt is less, at about UK£38.0b.

A Look At British American Tobacco's Liabilities

According to the last reported balance sheet, British American Tobacco had liabilities of UK£16.2b due within 12 months, and liabilities of UK£57.3b due beyond 12 months. Offsetting this, it had UK£4.13b in cash and UK£4.38b in receivables that were due within 12 months. So its liabilities total UK£64.9b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's massive market capitalization of UK£58.8b, we think shareholders really should watch British American Tobacco's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

British American Tobacco has net debt to EBITDA of 2.6 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.3 times its interest expense, and its net debt to EBITDA, was quite high, at 2.6. Importantly, British American Tobacco grew its EBIT by 36% over the last twelve months, and that growth will make it easier to handle its debt. 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 British American Tobacco'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, British American Tobacco recorded free cash flow worth a fulsome 80% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

British American Tobacco's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. But truth be told its level of total liabilities had us nibbling our nails. Considering this range of data points, we think British American Tobacco is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for British American Tobacco you should know about.

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.