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 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 can see that Cleveland-Cliffs Inc. (NYSE:CLF) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Cleveland-Cliffs Carry?
The image below, which you can click on for greater detail, shows that Cleveland-Cliffs had debt of US$5.03b at the end of March 2022, a reduction from US$5.73b over a year. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Cleveland-Cliffs' Balance Sheet?
The latest balance sheet data shows that Cleveland-Cliffs had liabilities of US$3.75b due within a year, and liabilities of US$9.41b falling due after that. Offsetting this, it had US$35.0m in cash and US$2.67b in receivables that were due within 12 months. So it has liabilities totalling US$10.5b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's US$8.23b market capitalization, you might well be inclined to review the balance sheet intently. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Cleveland-Cliffs's net debt is only 0.80 times its EBITDA. And its EBIT covers its interest expense a whopping 16.4 times over. 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 1,958% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Cleveland-Cliffs's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Cleveland-Cliffs's free cash flow amounted to 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Both Cleveland-Cliffs's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. Looking at all this data makes us feel a little cautious about Cleveland-Cliffs's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Cleveland-Cliffs is showing 5 warning signs in our investment analysis , and 1 of those can't be ignored...
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.