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 A Problem?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Cleveland-Cliffs’s Net Debt?
As you can see below, Cleveland-Cliffs had US$2.09b of debt at September 2019, down from US$2.30b a year prior. However, because it has a cash reserve of US$399.3m, its net debt is less, at about US$1.69b.
How Strong Is Cleveland-Cliffs’s Balance Sheet?
The latest balance sheet data shows that Cleveland-Cliffs had liabilities of US$458.5m due within a year, and liabilities of US$2.67b falling due after that. Offsetting this, it had US$399.3m in cash and US$223.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.51b.
When you consider that this deficiency exceeds the company’s US$2.00b 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.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Cleveland-Cliffs has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 5.0 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Shareholders should be aware that Cleveland-Cliffs’s EBIT was down 22% 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. There’s no doubt that we learn most about debt from the balance sheet. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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 33% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Mulling over Cleveland-Cliffs’s attempt at (not) growing its EBIT, we’re certainly not enthusiastic. But at least its interest cover is not so bad. Overall, it seems to us that Cleveland-Cliffs’s balance sheet is really quite a risk to the business. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. 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. Take risks, for example – Cleveland-Cliffs has 4 warning signs (and 2 which are concerning) we think you should know about.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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