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. As with many other companies The Williams Companies, Inc. (NYSE:WMB) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.
How Much Debt Does Williams Companies Carry?
The chart below, which you can click on for greater detail, shows that Williams Companies had US$22.4b in debt in March 2022; about the same as the year before. However, because it has a cash reserve of US$604.0m, its net debt is less, at about US$21.8b.
How Healthy Is Williams Companies' Balance Sheet?
According to the last reported balance sheet, Williams Companies had liabilities of US$4.31b due within 12 months, and liabilities of US$27.8b due beyond 12 months. Offsetting these obligations, it had cash of US$604.0m as well as receivables valued at US$1.97b due within 12 months. So its liabilities total US$29.5b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of US$38.1b, so it does suggest shareholders should keep an eye on Williams Companies' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Williams Companies's debt to EBITDA ratio (4.9) suggests that it uses some debt, its interest cover is very weak, at 2.2, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. More concerning, Williams Companies saw its EBIT drop by 4.8% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Williams Companies can strengthen its balance sheet over time. 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. During the last three years, Williams Companies generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Williams Companies's interest cover and net debt to EBITDA definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Williams Companies 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 3 warning signs for Williams Companies you should be aware of, and 1 of them is a bit unpleasant.
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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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.