Is Cleveland-Cliffs (NYSE:CLF) Using Too Much Debt?

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 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. We note that Cleveland-Cliffs Inc. (NYSE:CLF) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Cleveland-Cliffs

How Much Debt Does Cleveland-Cliffs Carry?

As you can see below, Cleveland-Cliffs had US$4.59b of debt at March 2023, down from US$5.03b a year prior. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Cleveland-Cliffs' Balance Sheet?

We can see from the most recent balance sheet that Cleveland-Cliffs had liabilities of US$3.46b falling due within a year, and liabilities of US$7.40b due beyond that. Offsetting this, it had US$59.0m in cash and US$2.22b in receivables that were due within 12 months. So its liabilities total US$8.58b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$8.39b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Cleveland-Cliffs has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.7 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Shareholders should be aware that Cleveland-Cliffs's EBIT was down 80% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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'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 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 44% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Cleveland-Cliffs's EBIT growth rate was disappointing. But at least its conversion of EBIT to free cash flow is not so bad. Overall, it seems to us that Cleveland-Cliffs's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. We've identified 2 warning signs with Cleveland-Cliffs , and understanding them should be part of your investment process.

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.