Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Cleveland-Cliffs Inc. (NYSE:CLF) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Cleveland-Cliffs's Debt?
As you can see below, Cleveland-Cliffs had US$4.67b of debt at June 2022, down from US$5.37b a year prior. Net debt is about the same, since the it doesn't have much cash.
How Healthy Is Cleveland-Cliffs' Balance Sheet?
According to the last reported balance sheet, Cleveland-Cliffs had liabilities of US$3.99b due within 12 months, and liabilities of US$9.06b due beyond 12 months. Offsetting these obligations, it had cash of US$47.0m as well as receivables valued at US$2.57b due within 12 months. So it has liabilities totalling US$10.4b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of US$7.04b, we think shareholders really should watch Cleveland-Cliffs's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).
Cleveland-Cliffs's net debt is only 0.77 times its EBITDA. And its EBIT easily covers its interest expense, being 16.6 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Cleveland-Cliffs grew its EBIT by 223% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Cleveland-Cliffs 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, 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. Looking at the most recent three years, Cleveland-Cliffs recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
While Cleveland-Cliffs's level of total liabilities has us nervous. To wit both its interest cover and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Cleveland-Cliffs is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Cleveland-Cliffs 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.
What are the risks and opportunities for Cleveland-Cliffs?
Trading at 61.2% below our estimate of its fair value
Earnings grew by 22.2% over the past year
Earnings are forecast to decline by an average of 25.9% per year for the next 3 years
Shareholders have been diluted in the past year
Has a high level of debt
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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.
Cleveland-Cliffs Inc. operates as a flat-rolled steel producer in North America.
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Undervalued with proven track record.