These 4 Measures Indicate That Cleveland-Cliffs (NYSE:CLF) Is Using Debt Extensively

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Cleveland-Cliffs Inc. (NYSE:CLF) makes use of debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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

What Is Cleveland-Cliffs's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Cleveland-Cliffs had debt of US$3.80b, up from US$3.48b in one year. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Cleveland-Cliffs' Balance Sheet?

According to the last reported balance sheet, Cleveland-Cliffs had liabilities of US$3.26b due within 12 months, and liabilities of US$6.45b due beyond 12 months. On the other hand, it had cash of US$39.0m and US$1.58b worth of receivables due within a year. So its liabilities total US$8.08b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$4.69b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Cleveland-Cliffs would likely require a major re-capitalisation if it had to pay its creditors today.

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.

While we wouldn't worry about Cleveland-Cliffs's net debt to EBITDA ratio of 3.5, we think its super-low interest cover of 0.47 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Cleveland-Cliffs's EBIT was down 83% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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.

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. During the last three years, Cleveland-Cliffs generated free cash flow amounting to a very robust 91% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

To be frank both Cleveland-Cliffs's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. 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. For instance, we've identified 1 warning sign for Cleveland-Cliffs that you should be aware of.

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.

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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.