Yara International (OB:YAR) Seems To Use Debt Quite Sensibly

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Yara International ASA (OB:YAR) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Yara International

What Is Yara International's Debt?

As you can see below, Yara International had US$3.62b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$579.0m in cash leading to net debt of about US$3.04b.

A Look At Yara International's Liabilities

The latest balance sheet data shows that Yara International had liabilities of US$5.90b due within a year, and liabilities of US$4.44b falling due after that. Offsetting these obligations, it had cash of US$579.0m as well as receivables valued at US$2.48b due within 12 months. So its liabilities total US$7.28b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of US$9.85b, so it does suggest shareholders should keep an eye on Yara International's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Yara International has a low net debt to EBITDA ratio of only 0.75. And its EBIT covers its interest expense a whopping 28.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Yara International grew its EBIT by 148% over twelve months. That boost will make it even easier to pay down debt going forward. 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 Yara International'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Yara International recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Yara International's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. Looking at all the aforementioned factors together, it strikes us that Yara International can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Yara International you should be aware of, and 1 of them shouldn't be ignored.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.